Final Exam Guide - Everything you need to know! (124 pages long)
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Ten Principles of Economics
•Society’s resources must be managed because resources are scarce.
oThe limited nature of resources is referred to as scarcity.
•The study of how society manages its scarce resources is called
•How People Make Decisions
oAn economy is a group of people or polity which interact with one
another as they live.
oPrinciple 1: Trade-offs:
Decisions require trading a resource for another.
Societies must make decisions, typically trading one thing in
degree for another.
•Efficiency is the property of society that allows it to
achieve maximum benefit from the scarcity of
•Equality is the property of society that distributes
economic prosperity equally among society.
oPrinciple 2: Opportunity Cost
Decisions require comparing the costs and benefits of other
•The opportunity cost of a decision is whatever must
be lost in order to complete the decision.
oPrinciple 3: Rational Behavior
People are usually rational.
Rational people systematically and purposefully perform
optimally to achieve their objectives within their opportunities.
The small incremental changes to existing plans of action are
referred to as marginal changes.
Rational people make many decisions by comparing marginal
benefits (the benefits behind a marginal change) and marginal
costs (the costs behind a marginal change).
•Rational behavior occurs if and only if the marginal
benefit of a decision exceeds the marginal cost.
oPrinciple 4: Incentives
An incentive is a factor that induces a person to specifically
•Punishments, such as taxes, are incentives.
•Rewards, such as tax breaks, are incentives.
•How People Interact
oPrinciple 5: Trade
Trade between different parties allow for a greater category of
goods and services.
oPrinciple 6: Markets Organize Economic Activity
Communist economies relied on a government or central
planner organizing economic activity.
Previous communist economies have abandoned the
decisions of the central planner and instead allocate their
resources through the decentralized decisions of many
independent firms and households interacting in a market for
good and services, a system known as a market economy.
According to Adam Smith, market economies are guided by an
“invisible hand” that leads markets to desirable outcomes.
When governments prevent prices from adjusting naturally to
supply and demand, the invisible hand is unable to coordinate
the decisions of the independent households and firms that
make up a market economy.
oPrinciple 7: Governments Can Improve Market Outcomes
Market economies require institutions, such as the
government that maintain and protect property rights.
•Property rights are the ability for an individual to own
and control their own scarce resources.
Governments typically interfere in markets through policies
that either promote efficiency or equality.
When a market economy left on its own fails to allocate
resources efficiently, it is called a market failure.
•An externality is when the decisions of an individual
impact the well-being of an uninvolved bystander.
oExternalities can cause market failures.
•The ability of an individual or a small group of
individuals to substantially impact the market is called
oIndividuals with market power can cause market
Market economies rewards those with an ability to produce
things that others are willing to pay for.
•The invisible hand does not achieve or assist equality.
•How the Economy as a Whole Works
oPrinciple 8: Standards Depend on Production
A polity’s standard of living depends on its ability to produce
goods and services.
•Almost all variations in the standard of living are related
to the quantity of goods and services produced from
each unit of labor input or a unit’s productivity.
oPrinciple 9: Inflation
The increase of quantity of currency decreases the value of
The increase in the overall level of prices in an economy is
oPrinciple 10: The Short-Run Trade-off Between Inflation and
The short-run effects of increasing the quantity of currency (or
monetary injections) are:
•Overall expenditure increases, increasing demand for
goods and services.
•The increase in demand causes sellers to raise their
prices while simultaneously looking to hire more
workers and produce a larger output of goods and
•An increasing in hiring means a decrease of
The irregular and unpredictable fluctuations in economic
activity, as measured by the changes in production or
employment, are described by a business cycle.
Societies must decide between the short-run trade-off
between inflation and unemployment.