Chapter 1: Ten Principles of Economics
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- Scarcity: limited nature of society's resources
- Economics:study of how society manages its scarce resources
How People Make Decisions
Principle #1: People Face Tradeoffs
- To get one thing we like, we usually have to give up another thing that we like.
- Tradeoff society faces -> efficiency vs. equity
• Efficiency: property of societygetting the most it can from its scarce resources
○ Refers to the size of the economicpie
• Equity: property of distributing economicprosperity fairly among the membersof society
○ Refers to how the economicpie is divided
Principle #2: The Cost of Something Is What You Give Up to Get It
- Making decisions requires comparing the costs & benefits of alternativecourses of action.
- Costs may not be obvious.
- Opportunitycost: whatever must be given up to obtain some item
Principle #3: Rational People Think at the Margin
- Rationalpeople:people who systematically& purposefully do the best they can to achieve their
- Marginalchanges: small incremental adjustments to a plan of action
- Rational people often make decisions by comparing marginal benefits & marginal costs.
Principle #4: People Respond to Incentives
- Incentive:something that induces a person to act
- Because rational people make decisions by comparing costs & benefits, they respond to incentives.
How People Interact
Principle #5: Trade Can Make EveryoneBetter Off
- Trade allows each person to specialize in the activities he/she does best. By trading with others,
people can buy a greater variety of goods & servicesat lower cost.
Principle #6: Markets Are Usually a Good Way to Organize EconomicActivity
- Market economy: economythat allocates resourcesthrough the decentralized decisions of many
firms & households as they interact in markets for goods & services
- Firms & households interact in the marketplace where prices & self-interest guide their decisions.
- Free markets contain many buyers & sellers of numerous goods & services,& all of them are
interested primarily in their own well-being.
- Households & firms are guided by an "invisible hand" that leads them to desirable market
- When the governmentprevents prices from adjusting naturally to supply & demand, it impedes the
invisible hand's ability to coordinate the households & firms that make up the economy.
Principle #7: GovernmentsCan SometimesImproveMarket Outcomes
- Markets work only if property rights (ability of an individual to own & exercise control over scarce
resources) are enforced.
- Need government -> invisible hand is powerful but not omnipotent
- 2 broad reasons for a gvt to intervene in the economy& change the allocation of resources that
people would chooseon their own: to promoteefficiency & to promoteequity
- Market failure: situation in which a market left on its own fails to allocate resources efficiently
• Possible causes:
○ Externality: impact of one person's actions on the well-being of a bystander (e.g. pollution)
Market power: ability of a single economicactor (or small group of actors) to have a substantial ○ Market power: ability of a single economicactor (or small group of actors) to have a substantial
influence on market prices
e.g. If everyonein town needs water but there is only 1 well, the owner of the well is not subject to
the rigorous competitionwith which the invisible hand normally keeps self-interest in check.
- Public policy can enhance economicefficiency (if externalities or market power are present).
- The invisible hand may fail to ensure economicprosperity is distributed equitably.
How the Economy as a Whole Works
Principle #8: A Country's Standard of Living Depends on Its Ability to Produce Goods and Services
- Almost all variation in living standards is due to the differences in countries' productivity:quantity of
goods & services produced from each hour of a worker's time.
• Nations that can produce a large quantity of goods & services per unit of time -> high standard of
• Nations that are less productive -> low standard of living
- Growth rate of nation's productivity determines the growth rate of its avg income
Principle #9: Prices Rise When the GovernmentPrints Too Much Money
- Inflation:↑ in the overall level of prices in the economy
• Cause -> growth in the quantity of money (value of money ↓)
Principle #10: Societyfaces a Short-Run Tradeoff between Inflation and Unemployment
- Short-run effects of monetaryinjections:
• Increasing the amount of money in the economystimulates the overall level of spending & thus the
demand for goods & 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 & services they produce & to hire more workers
to produce those goods & services.
• More hiring means lower unemployment.
○ Leads to economy-widetradeoff -> short-run tradeoff between inflation & unemployment
Means over a period of 1 or 2 years, economicpolicies push inflation & unemploymentin opp
Short-run tradeoff plays key role in analysis of the business cycle: fluctuations in economicactivity,
such as employment& production
- By changing the amount that the governmentspends, the amount it taxes, & the amount of money
it prints, policymakerscan influence the combinationof inflation & unemploymentthat the
economyexperiences. Chapter 2: Thinking Like an Economist
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The Economist as Scientist
- Scientific method: dispassionate development& testing of theories about how the world works
The Role of Assumptions
- Assumptions can simplify the complex world & make it easier to understand.
• e.g. To study international trade, assume 2 countries & 2 goods.
○ Unrealistic but simple to learn and gives useful insights about the real world
- Does not include every feature of the economy -> many details of economyare irrelevant
Our First Model: The Circular-Flow Diagram
- Circular-flowdiagram: visual model of the economythat shows how $ flows through markets
among households & firms (Figure 2.1 (p.25))
• Economyis simplified to include 2 types of decision makers -> households & firms
• Firms produce goods & servicesusing inputs (factors of production), such as natural resourcesor
• Households own the factors of production & consume all the goods & services that the firms
• Households & firms interact in 2 types of markets.
○ Marketsfor goods & services -> households = buyers, firms = sellers
○ Marketsfor the factors of production -> households = sellers, firms = buyers
• Inner loop -> corresponding flow of inputs & outputs
○ Factors of production flow from households to firms, & goods & servicesflow from firms to
• Outer loop -> flow of $
○ Spending on goods & services flows from households to firms, & income in the form of wages, rent,
& profit flows from firms to households.
Our Second Model: The Production Possibilities Frontier
- Graph that shows the combinationsof output that the economycan possibly produce given the
available factors of production & the available production technology
- Figure 2.2 (p.27) -> points on (efficient) or inside (inefficient) = attainable, points outside =
- Source of inefficiency eliminated -> ↑ production on both goods
- Shows one tradeoff -> After reaching the efficient points on the frontier, the only way of getting
more of 1 good is to get less of the other (opportunity cost).
- Opportunity cost = slope of PPF (highest when PPF is steepest)
- Shape of the PPF:
• The PPF could be a straight line, or bow-shaped
• Depends on what happens to opportunity cost as economyshifts resources from one industry to
○ If opportunity cost remains constant, PPF is a straight line
○ If opportunity cost ↑ as the economyproduces more of the good, PPF is bow-shaped
- Figure 2.3 (p.29) -> economicgrowth shifts PPF outward
- Microeconomics:study of how households & firms make decisions & how they interact in markets
- Macroeconomics: study of economy-widephenomena (inflation, unemployment,economicgrowth)
The Economist as Policy Adviser
- Recommendpolicies to improveeconomicoutcomes Positiveversus NormativeAnalysis
- Positive statements: claims that attemptto describe the world as it is
○ Can be confirmed or refuted with evidence
- Normative statements: claims that attemptto prescribe how the world should/ought to be
○ Involves values & value judgments rather than facts
Why Economists Disagree
- Economistsmay disagree about the validity of alternative positivetheories about how the world
- Economistsmay have different values and, therefore, different normativeviews about what policy
should try to accomplish.
- Difference in scientific judgments & differences in values -> disagreement is inevitable
- In many cases, economistsdo offer a united view, but policymakersmay choose to ignore it. Chapter 5: Measuring a Nation's Income
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The Economy's Income and Expenditure
- GDP measures 2 things at once: the total income of everyonein the economy& the total
expenditure of the economy'soutput of goods & services.
- Income = Expenditure
• True because every transaction has 2 parties: a buyer & a seller. Every $ of spending by some buyer
is a $ of income for some seller. Also refer to the circular-flow diagram.
- Can computeGDP in 2 ways -> adding up total expenditure by households or by adding up total
income (wages, rent, & profit) paid by firms (all expenditure ends up as someone'sincome -> GDP is
The Measurement of Gross Domestic Product
- Gross domesticproduct(GDP): market value of all final goods & services produced within a country
in a given period of time
"GDP Is the Market Value…"
- GDP adds together many different kinds of products into a single measure of the value of economic
activity. To do this, it uses market prices. Market prices measure the amount people are willing to
pay for different goods, so they reflect the value of those goods.
- GDP includes all items produced in the economy& sold legally in markets.
- Includes the market value of housing services
• Rental housing -> rent = tenant's expenditure & landlord's income
• Owner-occupied housing -> estimating rental value (pays rent to himself, included both in
expenditure & income)
- GDP excludes items produced & consumed at home, & therefore,never enter the marketplace.
- GDP includes only the value of final goods. The value of intermediate goods is already included in the
prices of the final goods. Adding the marketvalue of the intermediate good to the marketvalue of
the final good would be double counting.
- When an intermediategood is produced & is added to a firm's inventoryof goods to be used or sold
at a later date, the intermediate good is taken to be "final" for the moment,& its value as inventory
investmentis added to GDP.
- GDP includes both tangible goods & intangible services.
- GDP includes goods & servicescurrently produced (reselling excluded).
"…Within a Country…"
- Items are included in a nation's GDP if they are produced domestically,regardless of the nationality
of the producer.
"…In a Given Period of Time"
- GDP measures the value of production that takes place within a specific interval of time (usually a
year or a quarter (3 months)).
- GDP is presented "at an annual rate" (amount of income & expenditure during the quarter × 4).
• Eliminates the seasonal cycle
The Components of GDP
- GDP = Consumption+ Investment+ Governmentpurchases + Net Exports
• Y = C + I + G + NX • Y = C + I + G + NX
- Spending by households on goods & services, with the exception of purchases of new housing
- Spending on capital equipment, inventories, & structures, including household purchases of new
- =/= financial investments, investment means purchases of goods used to produce other goods
- Spending on goods & services by local, territorial, provincial, & federal governments
- Includes the salaries of governmentworkers& spending on public works
- Transfer payments (e.g. CPP to elderly) alter household income but do not reflect the economy's
• Not included as part of governmentpurchases
- Net exports = Nation's exports - Nation's imports (trade balance)
- Imports are subtracted because imports of goods & servicesare included in other componentsof
- Net exports include goods & services produced abroad (-) because these goods & services are
included in C, I, & G (+). Thus, a purchase from abroad reduces net exports but because it also raises
C, I, or G, it does not affect GDP.
Real Versus Nominal GDP
- If total spending ↑ from 1 year to the next, 1 of 2 things must be true:
1. The economyis producing a larger output of goods & services.
2. Goods & services are being sold at higher prices.
- Want a measure of total quantity of goods & services the economyis producing that is not affected
by changes in the prices of those goods & services -> use real GDP -> shows how the economy's
overall production of goods & services changes over time
A Numerical Example
- Table 5.3 (p.107)
- NominalGDP: production of goods & services valued at current prices
- Real GDP: production of goods & servicesvalued at constant prices
• First choose 1 year as a base year -> use prices in the base year to compute value of goods & services
in all of the years
○ Prices in the base year provide the basis for comparing quantities in different years
○ For the base year, real GDP always = nominal GDP
• ↑ attributable to ↑ in the quantities produced when prices are being held fixed at base-year levels
- Nominal GDP uses current prices to place a value on the economy's production of goods & services.
Real GDP uses constant base-year prices to place a value on the economy's production of goods &
- Real GDP is not affected by changes in prices. Changes in real GDP reflect only changes in the
amounts being produced.
- Real GDP is a better economicindicator of economicwell-being than nominal GDP.
• Real GDP measures the economy'sproduction of goods & services -> economy'sability to satisfy
people's needs & wants
- GDP -> normally refer to real GDP
- Growth in the economy -> measure growth as a % Δ in real GDP from 1 period to another
The GDP Deflator
- Measure of the price level calculated as the ratio of nominal GDP to real GDP × 100
• GDP deflator = Nominal GDP ÷ Real GDP × 100
- Reflects the prices of goods & services but not the quantities produced
- GDP deflator for base year always = 100 (nominal GDP = real GDP for base year) - GDP deflator for base year always = 100 (nominal GDP = real GDP for base year)
- Other years -> measures change in nominal GDP from the base year that cannot be attributable to
change in real GDP
- Measures the current level of prices relative to the level of prices in the base year
• Constant prices, quantities produced ↑ -> both nominal & real GDP ↑ -> GDP deflator is constant
• Prices ↑, quantities produced constant -> nominal GDP ↑ but constant real GDP -> GDP deflator ↑
- Inflation: situation in which the economy'soverall price level is ↑
- Inflation rate: % Δ in some measure of the price level from 1 period to the next
• Inflation rate in year 2 = (GDP deflator in year 2 - GDP deflator in year 1) ÷ GDP deflator in year 1 ×
- Measure that economistsuse to monitor the avg level of prices in the economy
GDP and Economic Well-Being
- Real GDP per capita is the main indicator of the average person’s standard of living.
- GDP is a good measure of economicwell-being because people prefer higher to lower incomes.But
GDP is not a perfect measure of well-being.
- GDP does not value:
• The quality of the environment
• Leisure time
• Non-market activity,such as the child care a parent provides his/her child at home
• An equitable distribution of income Chapter 6: Measuring the Cost of Living
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The Consumer Price Index
- Consumerprice index (CPI): measure of the overall cost of the goods & services bought by a typical
How the Consumer Price Index is Calculated
- 5 steps (Table 6.1 (p.123))
1. Determinethe basket.
○ Determinewhich prices are most importantto the typical consumer
○ If the typical consumer buys more hot dogs than drinks, then the price of hot dogs is more
2. Find the prices.
3. Compute the basket's cost.
4. Choose a base year & computethe index.
○ Designate 1 year as the base year
○ Choice of base year is random, as the index is used to measure changes in the cost of living
○ CPI = Price of basket of goods or servicesin current year ÷ Price of basket in base year × 100
○ CPI will always be 100 for the base year
○ If the CPI is 175 in 2009,the price of the basket in 2009 is 175%of its price in the base year.
5. Compute the inflation rate.
○ Inflationrate: % Δ in the price index from the preceding period
Inflation rate in year 2 = (CPI in year 2 - CPI in year 1) ÷ CPI in year 1 × 100
○ Core inflation:measure of the underlying trend of inflation
Excludes the most volatile componentsfrom the CPI basket of goods & services
Problemsin Measuring the Cost of Living
- Commodity substitution bias
• When prices change from one year to the next, they do not all change proportionately:some prices
rise more than others. Consumers substitute toward goods that have becomerelativelyless
expensive. If a price index is computed assuming a fixed basket of goods, it ignores the possibility of
consumer substitution. Thus, CPI overstatesthe ↑ in the cost of living from one year to the next.
- Introduction of new goods
• Greater variety makes each $ more valuable, so consumers need fewer $ to maintain any given
standard of living. Since the CPI is based on a fixed basket, it does not reflect the ↑ in the value of
- Unmeasured quality change
• If the quality of a good deterioratesfrom 1 year to the next, the value of a $ ↓, even if the price of
the good stays the same and vice-versa.
• StatsCan adjusts the price of the good to account for the quality change -> still a problem -> hard to
The GDP Deflator versus the Consumer Price Index
• The GDP deflator reflects the prices of all goods & services produced domestically, whereas the CPI
reflects the prices of all goods & services bought by consumers.
• The CPI compares the price of a fixed basket of goods & services to the price of the basket in the
base year. StatsCan changes the basket of goods only every4 years. The GDP deflator compares the
price of currently produced goods & services to the price of the same goods & servicesin the base
year. Thus, the group of goods & services used to compute the GDP deflator changes automatically
over time. This difference is not important when all prices are changing proportionately.If the prices
of different goods & services are changing by varying amounts, the way we weight the various prices
matters for the overall inflation rate.
- Figure 6.2 (p.127)
CorrectingEconomic Variables for the Effects of Inflation CorrectingEconomic Variables for the Effects of Inflation
Dollar Figures from Different Times
- To inflate past prices to today's prices:
Value in current year $ = Past year nominal value × (CPI in the current year ÷ CPI in the past year)
- To deflate today's prices into past year prices:
Value in past year $ = Current year value × (CPI in the past year ÷ CPI in the current year)
- The automatic correctionof a $ amount for the effects of inflation by law or contract
- Many long-term contractsbetween firms & unions include partial or completeindexation of the
wage to the CPI (cost-of-living allowance (COLA)). A COLA automaticallyraises the wage when the
- CPP & Old Age Security benefits are adjusted everyyear to compensatethe elderly for ↑ in prices.
The brackets of the federal income tax (the incomelevels at which the tax rates change) are also
index for inflation.
Real and Nominal Interest Rates
- Interest represents a payment in the future for a transfer of money in the past. Interest rates always
involve comparing amounts of money at different points in time.
- If prices have risen while money was in the bank, each $ now buys less than it did a year ago.
- ↑ rate of inflation, the smaller the ↑ in purchasing power
- Rate of inflation > rate of interest -> purchasing power ↓
- Deflation (neg rate of inflation) -> purchasing power ↑ more than rate of interest
- Nominalinterest rate: interest rate as usually reported without a correctionfor the effects of
• Shows how fast the # of $ in bank account ↑ over time
○ High nominal interest rates, high inflation -> real interest rates relativelylow
○ Low nominal interest rates, low inflation -> real interest rates relatively high
- Real interest rate: interest rate correctedfor the effects of inflation
• Real interest rate = Nominal interest rate - Inflation rate Chapter 7: Production and Growth
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Productivity:Its Role and Determinants
Why ProductivityIs So Important
- Productivity: quantity of goods & services produced from each hour of a worker's time
• Key determinant of living standards
• Growth in productivity = key determinant of growth in living standards
- Economy'sincome = economy'soutput
- A nation can enjoy a high standard of living only if it can produce a large quantity of goods &
How Productivity Is Determined
Physical Capital per Worker
- Workers are more productive if they have tools with which to work.
- Physicalcapital/capital: stock of equipment & structures that are used to produce goods & services
• A produced factor of production -> input into the production process that in the past was an output
from the production process (e.g. woodworkeruses lathe but the lathe was the output of a firm that
Human Capital per Worker
- Human capital: knowledge & skills that workersacquire through education, training, & experience
• Like physical capital
○ Raises a nation's ability to produce goods & services
○ A produced factor of production -> Students can be viewed as "workers"who have the important
job of producing the human capital that will be used in future production.
○ The amount of time the population devotesitself
Natural Resources per Worker
- Natural resources: inputs into the production of goods & services that are provided by nature
• 2 forms -> renewable (e.g. forest) & nonrenewable (e.g. oil)
- Technologicalknowledge: society'sunderstanding of the best ways to produce goods & services
• Commonknowledge -> after it becomesused by 1 person, everyonebecomesaware of it
• Proprietary -> known only by the co that discoversit (e.g. only Coca-Cola knows its secret recipe)
○ Other tech -> proprietary for short time (e.g. drugs with a patent)
Economic Growth and Public Policy
The Importance of Saving and Investment
- To raise future productivity -> invest more current resourcesin the production of capital
- Devotingmore resources to producing capital = devoting fewer resources for current consumption
- For society to invest more in capital, it must consume less & save moreof its current income. It
requires that society sacrifice consumption of goods & services in the present in order to enjoy
higher consumptionin the future.
Diminishing Returns and the Catch-Up Effect
- Capital ↑ -> productivity ↑ & morerapid growth in GDP
- Diminishingreturns: property whereby the benefit from an extra unit of an input ↓ as the quantity
of the input ↑
• As the stock of capital ↑, the extra output produced from an additional unit of capital ↓ (Figure 7.1
- As the higher saving rate allows more capital to be accumulated, the benefits from additional capital
becomesmaller over time, & so growth slows down.
- In the long run, the higher saving rate leads to a higher level of productivity & income, but not to
higher growth in these variables.
- Catch-upeffect: the property whereby countries that start off poor tend to grow more rapidly than
countries that start off rich Investmentfrom Abroad
- Foreign direct investment: capital investmentthat is owned & operated by a foreign entity
- Foreign portfolio investment: investmentthat is financed from foreign money but operated by
- Foreigners expect to earn a return on their investment
- ↑ economy'sstock of capital -> ↑ productivity & ↑ wages
- Investmentin human capital -> opp cost is foregonewages
- Important for eco