ECN 204 Chapter Notes -Invisible Hand, Demand For Money, Market Failure

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25 Apr 2012

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Chapter 1- Ten Principals of Economics
- Management of society’s resources is important because resources are scarce
Scarcity: the limited nature of society’s resources
Economics: the study of how society manages its scarce resources
- Resources are allocated not by a single central planner but through the combined actions of
millions of households and firms
Principle #1: People Face Tradeoffs
- One tradeoff that a society faces is between efficiency and equity
Efficiency: the property of society getting the most it can from its scarce resources
Equity: the property of distributing economic prosperity fairly among the members of society
- Efficiency refers to the size of the economic pie, equity refers to how the pie is divided
Principle #2: The Cost of Something Is What You Give Up to Get It
Opportunity Cost: whatever must be given up to obtain some item
Principle #3: Rational People Think at the Margin
Rational People: people who systematically and purposefully do the best they can to achieve
their objectives
Marginal Changes: small incremental adjustments to a plan of action
- Rational people often make decisions by comparing marginal benefits and marginal costs
Principle #4: People respond to Incentives
Incentive: something that induces a person to act
- Public policymakers should never forget about incentives because many policies change the
costs and benefits that people face and, therefore, alter behavior
Principle #5: Trade Can Make Everyone Better Off
- 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
Market Economy: an economy that allocates resources through the decentralized decisions of
many firms and households as they interact in markets for goods and services
- Market economies are good at organizing economic activity in a way that promotes overall
economic well-being, despite decentralized decision making and self-interested decision
- Adam Smith: households and firms interacting in markets act as if they are guided by an
“invisible hand” that leads them to desirable market outcomes
- Prices are the instrument with which the invisible hand directs economic activity
- When the government prevents prices from adjusting naturally to supply and demand, it
impedes the invisible hand’s ability to coordinate households and firms (the economy)
- Example: taxes distort prices and thus the decisions of households and firms
- Adam Smith:
- Individuals are usually best left to their own devices, without the heavy hand of
government guiding their actions
- Participants in the economy are motivated by self-interest
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- The “invisible hand” of the marketplace guides the self-interest into promoting general
economic well-being
Principle #7: Governments Can Sometimes Improve Market Outcomes
- The “invisible hand” concept can work only if the government enforces the rules and maintains
the institutions that are key to a market economy
- Markets work only if property rights are enforced
Property Rights: the ability of an individual to own and exercise control over scarce resources
- Two reasons for a government to intervene in the economy and change the allocation of
resources that people would choose on their own:
- To promote efficiency
- To promote equity
- Most government policies aim either to enlarge the economic pie or to change how the pie is
Market Failure: a situation in which a market left on its own fails to allocate resources efficiently
- Two possible reasons for market failure:
- Externalities
- Market power
Externality: the impact of one person’s actions on the well-being of a bystander
Market Power: the ability of a single economic actor (or small group of actors) to have a
substantial influence on market prices
- The “invisible hand” fails to ensure that economic prosperity is distributed evenly
- It doesn’t ensure that everyone has sufficient food, decent clothing, adequate health
care, etc.
Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and
- Almost all variation in living standards is attributed to differences in countries’ productivity
- In nations where workers can produce a large quantity of goods and services per unit of
time, most people enjoy a high standard of living
- Growth rate of a nation’s productivity determines the growth rate of its average income
Productivity: the quantity of goods and services produced from each hour of a workers time
- To raise living standards, policymakers need to raise productivity by ensuring that workers are
well educated, have the tools needed to produce goods and services, and have access to the best
available technology
Principle #9: Prices Rise When the Government Prints Too Much Money
Inflation: an increase in the overall level of prices in the economy
- When a government creates large quantities of money, the value of the money falls
Principle #10: Society Faces a Short-Run Tradeoff between Inflation and Unemployment
- Short-run effects of monetary injections:
- Increasing the amount of money in the economy stimulates the overall level of spending
and thus the demand for goods and services
- Higher demand may, over time, cause firms to raise their prices, but in the meantime, it
also encourages them to increase the quantity of goods and services they produce and to
hire more workers to produce those goods and service
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- More hiring means lower unemployment
- This short-run tradeoff plays a key role in the analysis of the business cycle
Business Cycle: fluctuations in economic activity such as employment and production
- By changing the amount that the government spends, the amount it taxes, and the amount of
money it prints, policymakers can influence the combination of inflation and unemployment
that the economy experiences
Chapter 2 - Thinking Like an Economist
Circular-Flow Diagram: a visual model of the economy that shows how dollars flow through
markets among households and firms
Factors of Production: labour, land (natural resources), and capital (buildings and machines)
Markets For Goods and Services: households are buyers and firms are sellers
Markets For the Factors of Production: households are sellers and firms are buyers
Production Possibilities Frontier: a graph that shows the combinations of output that the
economy can possibly produce given the available factors of production and the available
production technology
- An outcome is said to be efficient if the economy is getting all it can from the scarce
resources it has available
Microeconomics: the study of how households and firms make decisions and how they interact
in markets
Macroeconomics: the study of economy-wide phenomena, including inflation, unemployment,
and economic growth
- When economists are trying to explain the world, they are scientists
- When economists are trying to help improve it, they are policy advisers
Positive Statements: claims that attempt to describe the world as it is
- Positive statements can be confirmed or refuted by examining evidence
- Economists use positive statement to explain how the economy works
Normative Statements: claims that attempt to prescribe how the world should be
- Evaluating normative statements involves values as well as facts
- Involves our views on ethics, religion, and political philosophy
- Economists use normative statements to explain how we can improve the economy
Chapter 4 - The Market Forces of Supply and Demand
Market: a group of buyers and sellers of a particular good or service
- Buyers determine the demand for the product
- Sellers determine the supply of the product
Competitive Market: a market in which there are many buyers and many sellers so that each has
a negligible impact on the market price
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