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CHAPTER
1 In this chapter,
look for the answers to these questions:

 What kinds of questions does economics address?

Basic Principles of Economics  What are the principles of how people make
decisions?
 What are the principles of how people interact?
 What are the principles of how the economy as a
whole works?

© 2009 South-Western, a part of Cengage Learning, all rights reserved 1

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What Economics Is All About The principles of

 Scarcity: the limited nature of society’s HOW PEOPLE
resources
MAKE DECISIONS
 Economics: the study of how society manages
its scarce resources, e.g.
 how people decide what to buy,
how much to work, save, and spend
 how firms decide how much to produce,
how many workers to hire
 how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs

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HOW PEOPLE MAKE DECISIONS HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs Principle #1: People Face Tradeoffs

All decisions involve tradeoffs. Examples: Example continues:

 Going to a party the night before your midterm  Study Economics vs Statistics
leaves less time for studying.
 Spending on Cloth/Food vs Vacation
 Having more money to buy stuff requires working  Guns vs Butter
longer hours, which leaves less time for leisure.
 Efficiency vs Equality
 Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.

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HOW PEOPLE MAKE DECISIONS HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs Principle #2: The Cost of Something Is
 Society faces an important tradeoff: What You Give Up to Get It
efficiency vs. equality  Making decisions requires comparing the costs
 Efficiency: when society gets the most from its and benefits of alternative choices.
scarce resources
 The opportunity cost of any item is
 Equality: when prosperity is distributed uniformly whatever must be given up to obtain it.
among society’s members
 Tradeoff: To achieve greater equality,  It is the relevant cost for decision making.
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
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HOW PEOPLE MAKE DECISIONS HOW PEOPLE MAKE DECISIONS

Principle #2: The Cost of Something Is Principle #3: Rational People Think at the
What You Give Up to Get It Margin
Examples: Rational people
The opportunity cost of…  systematically and purposefully do the best they
…going to college for a year is not just the tuition, can to achieve their objectives.
books, and fees, but also the foregone wages.  make decisions by evaluating costs and benefits
…seeing a movie is not just the price of the ticket, of marginal changes – incremental adjustments
but the value of the time you spend in the theater. to an existing plan.

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HOW PEOPLE MAKE DECISIONS HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Principle #3: Rational People Think at the
Margin Margin
Examples: Examples:
 When a student considers whether to go to  Diamond-water paradox
college for an additional year, he compares the  An airline taking an extra passenger when the
fees & foregone wages to the extra income flight isn’t full
he could earn with the extra year of education.
 When a manager considers whether to increase
output, she compares the cost of the needed
labor and materials to the extra revenue.

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HOW PEOPLE MAKE DECISIONS ACTIVE LEARNING 1

Principle #4: People Respond to Incentives Applying the principles
 Incentive: something that induces a person to You are selling your 1996 Mustang. You have
act, i.e. the prospect of a reward or punishment. already spent $1000 on repairs.

 Rational people respond to incentives. At the last minute, the transmission dies. You can
pay $600 to have it repaired, or sell the car “as is.”
Examples:
 When gas prices rise, consumers buy more In each of the following scenarios, should you
hybrid cars and fewer gas guzzling SUVs. have the transmission repaired? Explain.
 When cigarette taxes increase, A. Blue book value is $6500 if transmission works,
teen smoking falls. $5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
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ACTIVE LEARNING 1 ACTIVE LEARNING 1

Answers Answers
Cost of fixing transmission = $600 Observations:
A. Blue book value is $6500 if transmission works,  The $1000 you previously spent on repairs is
$5700 if it doesn’t irrelevant. What matters is the cost and benefit
Benefit of fixing the transmission = $800 of the marginal repair (the transmission).
($6500 – 5700).
 The change in incentives from scenario A
It’s worthwhile to have the transmission fixed. to scenario B caused your decision to change.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
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HOW PEOPLE INTERACT

The principles of
Principle #5: Trade Can Make Everyone
HOW PEOPLE Better Off
INTERACT  Rather than being self-sufficient, people can
specialize in producing one good or service and
exchange it for other goods.
 Countries also benefit from trade & specialization:
 Get a better price abroad for goods they produce
 Buy other goods more cheaply from abroad than
could be produced at home

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HOW PEOPLE INTERACT HOW PEOPLE INTERACT

Principle #6: Markets Are Usually A Good Way Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity to Organize Economic Activity

 Market: a group of buyers and sellers  A market economy allocates resources through
(need not be in a single location) the decentralized decisions of many households
and firms as they interact in markets.
 “Organize economic activity” means determining
 what goods to produce  Famous insight by Adam Smith in
The Wealth of Nations (1776):
 how to produce them
Each of these households and firms
 how much of each to produce acts as if “led by an invisible hand”
 who gets them to promote general economic well-being.

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HOW PEOPLE INTERACT HOW PEOPLE INTERACT

Principle #6: Markets Are Usually A Good Way Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity to Organize Economic Activity
 The invisible hand works through the price system:
 The interaction of buyers and sellers
determines prices.
 Each price reflects the good’s value to buyers
and the cost of producing the good.
 Prices guide self-interested households and
firms to make decisions that, in many cases,
maximize society’s economic well-being.
http://www.youtube.com/watch?v=4ERbC7JyCfU
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HOW PEOPLE INTERACT HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes Principle #7: Governments Can Sometimes
Improve Market Outcomes Improve Market Outcomes

 Important role for govt: enforce property rights  Market failure: when the market fails to allocate
(with police, courts) society’s resources efficiently
 People are less inclined to work, produce, invest,  Causes:
or purchase if large risk of their property being  Externalities, when the production or consumption
stolen. of a good affects bystanders (e.g. pollution)
 A restaurant won’t serve meals if customers do not  Market power, a single buyer or seller has
pay before they leave. substantial influence on market price (e.g. monopoly)
 A music company won’t produce CDs if too many  In such cases, public policy may promote efficiency.
people avoid paying by making illegal copies.
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HOW PEOPLE INTERACT ACTIVE LEARNING 2

Principle #7: Governments Can Sometimes Discussion Questions
Improve Market Outcomes In each of the following situations, what is the
government’s role? Does the government’s
 Govt may alter market outcome to promote equity intervention improve the outcome?
 If the market’s distribution of economic well-being a. Workplace safety regulations
is not desirable, tax or welfare policies can change
how the economic “pie” is divided. b. Patent laws, which allow drug companies to
charge high prices for life-saving drugs

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The principles of HOW THE ECONOMY AS A WHOLE WORKS

Principle #8: A country’s standard of living
HOW THE
depends on its ability to produce goods &
ECONOMY services.
AS A WHOLE  Huge variation in living standards across
WORKS countries and over time:
 Average income in rich countries is more than
ten times average income in poor countries.
 The U.S. standard of living today is about
eight times larger than 100 years ago.

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HOW THE ECONOMY AS A WHOLE WORKS HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living Principle #9: Prices rise when the
depends on its ability to produce goods & government prints too much money.
services.
 Inflation: increases in the general level of prices.
 The most important determinant of living standards:  In the long run, inflation is almost always caused by
productivity, the amount of goods and services excessive growth in the quantity of money, which
produced per unit of labor. causes the value of money to fall.
 Productivity depends on the equipment, skills, and  The faster the govt creates money,
technology available to workers.
the greater the inflation rate.
 Other factors (e.g., labor unions, competition from
abroad) have far less impact on living standards.
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HOW THE ECONOMY AS A WHOLE WORKS HOW THE ECONOMY AS A WHOLE WORKS
Principle #10: Society faces a short-run Principle #10: Society faces a short-run
tradeoff between inflation and unemployment tradeoff between inflation and unemployment
 In the short-run (1 – 2 years),  Most economists describe the short-run effects of
many economic policies push inflation and monetary injections as follows:
unemployment in opposite directions.  Higher demand may over time cause firms to
 Most economists describe the short-run effects of raise their prices, but in the meantime, it also
encourages them to hire more workers and
monetary injections as follows:
produce a larger quantity of goods and services.
 Increasing the amount of money in the economy  More hiring means lower unemployment.
stimulates the overall level of spending and thus
the demand for goods and services.  Other factors can make this tradeoff more or less
favorable, but the tradeoff is always present.
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Class Discussion Class Discussion

 Describe some of the trade-offs faced by each of  You win Tk 10,000 in a basketball pool. You have
the following: a choice between spending the money now and
 a family deciding whether to buy a new car putting it away for a year in a bank account that
 a member of Parliament deciding how much to pays 5 percent interest. What is the opportunity
spend on national parks cost of spending the Tk 10,000 now?
 a company president deciding whether to open
a new factory
 a professor deciding how much to prepare for
class
 a recent college graduate deciding whether to
go to graduate school

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Class Discussion Class Discussion

 The company that you manage has invested Tk  Explain whether each of the following government activities is
motivated by a concern about equality or a concern about
5 million in developing a new product, but the
efficiency. In the case of efficiency, discuss the type of market
development is not quite finished. At a recent failure involved.
meeting, your salespeople report that the  a. regulating cable TV prices
introduction of competing products has reduced  b. providing some poor people with vouchers that can be
the expected sales of your new product to Tk 3 used to buy food
 c. prohibiting smoking in public places
million.
 d. breaking up Standard Oil (which once owned 90 percent
 If it would cost Tk 1 million to finish development of all U.S. oil refineries) into several smaller companies
and make the product, should you go ahead and  e. imposing higher personal income tax rates on people
do so? with higher incomes
 What is the most that you should pay to  f. enacting laws against driving while intoxicated
complete development?
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Class Discussion Class Discussion

 Discuss each of the following statements from  A 1996 bill reforming the federal government’s
the standpoints of equality and efficiency. antipoverty programs limited many welfare
 a. “Everyone in society should be guaranteed recipients to only 2 years of benefits.
the best healthcare possible.” a. How does this change affect the incentives
 b. “When workers are laid off, they should be for working?
able to collect unemployment benefits until they
find a new job.” b. How might this change represent a trade-
off between equality and efficiency?

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HOW THE ECONOMY AS A WHOLE WORKS

Thank You!

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