LEARNING OBJECTIVES:

By the end of this chapter, you should understand:

Ø       that economics is about the allocation of scarce resources.

Ø       that individuals face trade-offs.

Ø       the meaning of opportunity cost.

Ø       how to use marginal reasoning when making decisions.

Ø       how incentives affect people’s behavior.

Ø       why trade among people or nations can be good for everyone.

Ø       why markets are a good, but not perfect, way to allocate resources.

Ø       what determines some trends in the overall economy.

KEY POINTS:

1.       The fundamental lessons about individual decision-making are that people face trade-offs among alternative goals, that the cost of any action is measured in terms of forgone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behavior in response to the incentives they face.

2.       The fundamental lessons about interactions among people are that trade can be mutually beneficial, that markets are usually a good way of coordinating trades among people, and that the government can potentially improve market outcomes if there is some sort of market failure or if the market outcome is inequitable.

3.       The fundamental lessons about the economy as a whole are that productivity is the ultimate source of living standards, that money growth is the ultimate source of inflation, and that society faces a short-run trade-off between inflation and unemployment.

CHAPTER OUTLINE:

I.          Introduction

A.         The word “economy” comes from the Greek word oikonomos meaning “one who manages a household.”

B.         This makes some sense because in the economy we are faced with many decisions (just as a household is).

C.         Fundamental economic problem: resources are scarce.

Part of learning economics is understanding a new vocabulary. Economists generally use very precise (and sometimes different) definitions for words that are commonly used outside of the economics discipline.

D.         Definition of scarcity: the limited nature of society’s resources.

            E.         Definition of economics: the study of how society manages its scarce resources.

II.         How People Make Decisions

A.         Principle #1: People Face Trade-offs

1.         “There is no such thing as a free lunch.” Making decisions requires trading one goal for another.

2.         Examples include how students spend their time, how a family decides to spend its income, how the U.S. government spends tax dollars, and how regulations may protect the environment at a cost to firm owners.

3.         A special example of a trade-off is the trade-off between efficiency and equity.

a.         Definition of efficiency: the property of society getting the maximum benefits from its scarce resources.

b.         Definition of equity: the property of distributing economic prosperity fairly among the members of society.

c.          For example, tax dollars paid by wealthy Americans and then distributed to those less fortunate may improve equity but lower the return to hard work and therefore reduce the level of output produced by our resources.

d.                   This implies that the cost of this increased equity is a reduction in the efficient use of our resources.

                        4.         Recognizing that trade-offs exist does not indicate what decisions should or will be made.

B.         Principle #2: The Cost of Something Is What You Give Up to Get It

1.         Making decisions requires individuals to consider the benefits and costs of some action.

2.         What are the costs of going to college?

a.         We cannot count room and board (at least all of the cost) because the student would have to pay for food and shelter even if he was not in school.

b.         We would want to count the value of the student’s time because he could be working for pay instead of attending classes and studying.

3.         Definition of opportunity cost: whatever must be given up in order to obtain some item.

C.         Principle #3: Rational People Think at the Margin

1.         Economists generally assume that people are rational.

            a.         Definition of rational: systematically and purposefully doing the best you can to achieve your objectives

            b.         Consumers want to purchase the bundle of goods and services that allows them the greatest level of satisfaction given their incomes and the prices they face. 

            c.          Firms want to produce the level of output that maximizes the profits they earn 

2.         Many decisions in life involve incremental decisions: Should I remain in school this semester? Should I take another course this semester? Should I study an additional hour for tomorrow’s exam? 

            a.         Definition of marginal changes: small incremental adjustments to a plan of action.

            b.         Example: Suppose that flying a 200-seat plane across the country costs the airline $100,000, which means that the average cost of each seat is $500. Suppose that the plane is minutes from departure and a passenger is willing to pay $300 for a seat. Should the airline sell the seat for $300? In this case, the marginal cost of an additional passenger is very small.

            c.          Another example: Why is water so cheap while diamonds are expensive?  Because water is plentiful, the marginal benefit of an additional cup is small.  Because diamonds are rare, the marginal benefit of an extra diamond is high.

D.         Principle #4: People Respond to Incentives

1.         Definition of incentive: something that induces a person to act.

2.         Because rational people make decisions by weighing costs and benefits, their decisions may change in response to incentives.

            a.         When the price of a good rises, consumers will buy less of it because its cost has risen.

            b.         When the price of a good rises, producers will allocate more resources to the production of the good because the benefit from producing the good has risen.

3.         Many public policies change the costs and benefits that people face. Sometimes policymakers fail to understand how policies alter incentives and behavior.

4.         Example: Seat belt laws increase the use of seat belts and lower the incentives of individuals to drive safely. This leads to an increase in the number of car accidents. This also leads to an increased risk for pedestrians

III.       How People Interact

A.         Principle #5: Trade Can Make Everyone Better Off

1.         Trade is not like a sports competition, where one side gains and the other side loses.

2.         Consider trade that takes place inside your home.  Your family is likely to be involved in trade with other families on a daily basis.  Most families do not build their own homes, make their own clothes, or grow their own food.

3.         Countries benefit from trading with one another as well.

4.         Trade allows for specialization in products that countries (or families) can do best.

B.         Principle #6: Markets Are Usually a Good Way to Organize Economic Activity

1.         Many countries that once had centrally planned economies have abandoned this system and are trying to develop market economies.

2.         Definition of 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.

3.         Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it. 

4.         When a government interferes in a market and restricts price from adjusting, household and firm decisions are not based on the proper information. Thus, these decisions may be inefficient.

5.         Centrally planned economies have failed because they did not allow the market to work.

6.         FYI:  Adam Smith and the Invisible Hand

a.         Adam Smith’s 1776 work suggested that although individuals are motivated by self-interest, an invisible hand guides this self-interest into promoting society’s economic well-being.

b.         Smith’s astute perceptions will be discussed more fully in the chapters to come.

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

1.         The invisible hand will only work if the government enforces property rights.

            a.         Definition of property rights: the ability of an individual to own and exercise control over scarce resources.

2.         There are two broad reasons for the government to interfere with the economy: the promotion of efficiency and equity.

3.         Government policy can be most useful when there is market failure.

a.         Definition of market failure: a situation in which a market left on its own fails to allocate resources efficiently.

4.         Examples of Market Failure

a.         Definition of externality: the impact of one person’s actions on the well-being of a bystander.

b.         Definition of market power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.

c.          Because a market economy rewards people for their ability to produce things that other people are willing to pay for, there will be an unequal distribution of economic prosperity.

5.         Note that the principle states that the government can improve market outcomes. This is not saying that the government always does improve market outcomes.

IV.        How the Economy as a Whole Works

A.         Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services

1.         Differences in living standards from one country to another are quite large.

2.         Changes in living standards over time are also great.

3.         The explanation for differences in living standards lies in differences in productivity.

4.         Definition of productivity: the quantity of goods and services produced from each hour of a worker’s time.

5.         High productivity implies a high standard of living.

6.         Thus, policymakers must understand the impact of any policy on our ability to produce goods and services.

B.         Principle #9: Prices Rise When the Government Prints Too Much Money

1.         Definition of inflation: an increase in the overall level of prices in the economy.

2.         When the government creates a large amount of money, the value of money falls.

3.         Examples: Germany after World War I (in the early 1920s) and the United States in the 1970s.

C.         Principle #10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

1.         Most economists believe that the short-run effect of a monetary injection is lower unemployment and higher prices.

            a.         An increase in the amount of money in the economy stimulates spending and increases the quantity of goods and services sold in the economy. The increase in the quantity of goods and services sold will cause firms to hire additional workers.

            b.         An increase in the demand for goods and services leads to higher prices over time.

2.         Some economists question whether this relationship still exists.

3.         The short-run trade-off between inflation and unemployment plays a key role in the analysis of the business cycle.

4.         Definition of business cycle: fluctuations in economic activity, such as employment and production.

5.         Policymakers can exploit this trade-off by using various policy instruments, but the extent and desirability of these interventions is a subject of continuing debate.

            D.         FYI: How to Read this Book

1.         Economics is very useful to understand, but it can be a difficult subject to grasp.

2.         There are five tips to make reading and understanding the material in the book easier.

                                    a.         Summarize, don’t highlight.

b.         Test yourself. At the end of each section of the text, you will find a “Quick Quiz.” Answers to these “Quick Quizzes” can be found in the back of this textbook.

                                    c.          Practice, practice, practice.

                                    d.         Go online and use the website for this text.

                                    e.         Study in groups.

                                    f.          Don’t forget the real world.