SUMMARY OF PRINCIPLES OF ECONOMICS Chapter 1 Ten Principles of Economics The word Economy comes from the Greek word

oikonomos, which means one who manages a household. A household and an economy face many decisions: Who will work? What goods and how many of them should be produced? What resources should be used in production? At what price should the goods be sold?

The household decide which members of the household do which task and what each members gets in return. In short, the household must allocate its scarce resources among its various members, taking into account each members abilities, efforts, and desire. This explanation also goes for the society. Society and Scarce Resources: The management of societys resources is important because resources are scarce. Scarcity. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have.

Just as the household cannot give every members everything he or she wants, the society cannot give every individual the highest standard of living to which he or she might aspire. Economics is the study of how society manages its scarce resources. HOW PEOPLE MAKE DECISIONS 1. People face trade-offs. 2. The cost of something is what you give up to get it. 3. Rational people think at the margin. 4. People respond to incentives. Principle #1: People Face Trade-offs. There is no such thing as a free lunch!

To get one thing, we usually have to give up another thing (trading off one goals against another). Guns v. butter The more we spend on national defense(gun) the less we can spend on consumer goods(butter) to raise our living standard. Food v. clothing Leisure time v. work Efficiency v. equity

Efficiency v. Equity Efficiency means society gets the most (maximum benefits) that it can from its scarce resources. Equity means the benefits of those resources are distributed fairly among the members of society.

Recognizing that people face trade-offs does not by itself tell us what decision they will or should make. Principle #2: The Cost of Something Is What You Give Up to Get It. Decisions require comparing costs and benefits of alternatives. Whether to go to college or to work? Whether to study or go out on a date? Whether to go to class or sleep in? The opportunity cost of an item is what you give up to obtain that item.

Example : Basketball star LeBron James understands opportunity costs and incentives. He chose to skip college and go straight from high school to the pros where he earns millions of dollars. Principle #3: Rational People Think at the Margin. Rational people are people who systematically and purposefully do the best they can to achieve their objectives, given the opportunity they have. Marginal changes are small, incremental adjustments to an existing plan of action. People make decisions by comparing costs and benefits at the margin.

A classic Question: Why is water so cheap, while diamonds are so expensive? Although water is essential, the marginal benefit of an extra cup of water is small because water Is plentiful, in contrast no one needs diamonds to survive but because diamond are so rare people consider the marginal benefit of an extra diamond to be large. Principle #4: People Respond to Incentives. Incentive is something that induces people to act. Marginal changes in costs or benefits motivate people to respond. People respond to incentive. Also it can alter behavior because of the change of the cost and benefit that people face, after the change of policies. Example : Tax on gasoline encourage people to drive smaller, more fuel-efficient cars. The tax also encourage people to take public transportation rather than drive. The decision to choose one alternative over another occurs when that alternatives marginal benefits exceed its marginal costs!

HOW PEOPLE INTERACT 5. Trade can make everyone better off. 6. Markets are usually a good way to organize economic activity. 7. Governments can sometimes improve economic outcomes. Principle #5: Trade Can Make Everyone Better Off. People gain from their ability to trade with one another. Competition results in gains from trading. Trade allows people to specialize in what they do best. By trading with other people can buy a greater variety of goods and services ant lower cost.

Principle #6: Markets Are Usually a Good Way to Organize Economic Activity. A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Households decide what to buy and who to work for. Firms decide who to hire and what to produce.

Adam Smith made the observation that households and firms interacting in markets act as if guided by an invisible hand.

Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions. The invisible hand guide economic activity through prices that formed naturally in market. As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole. The prices reflect the value of goods to society and the cost of society for making the good. The buyers look at the price to decide how much to demand and for the sellers to decide how much to supply. Example : The fall of communism caused by the failure of their economic planners because they dont know the actual prices of goods. They fail because they tried to run economy with tying the invisible hands

Principle #7: Governments Can Sometimes Improve Market Outcomes. Markets work only if property rights are enforced (one of the reason why we need govermnets). Property rights are the ability of an individual to own and exercise control over a scarce resource

Market failure occurs when the market fails to allocate resources efficiently. When the market fails (breaks down) government can intervene to promote efficiency (allocating resources) and equity (economic prosperity distribution not always equal). Market failure may be caused by: an externality, which is the impact of one person or firms actions on the wellbeing of a bystander (e.g. pollution). market power, which is the ability of a single person or firm to unduly influence market prices (e.g. monopoly).

HOW THE ECONOMY AS A WHOLE WORKS 8. A countrys standard of living depends on its ability to produce goods and services. 9. Prices rise when the government prints too much money. 10. Society faces a short-run trade-off between inflation and unemployment. Principle #8: A Countrys Standard of Living Depends on Its Ability to Produce Goods and Services.

Almost all variations in living standards are explained by differences in countries productivities. Productivities affect living standard. Productivity is the amount of goods and services produced from each hour of a workers time. Standard of living may be measured in different ways: By comparing personal incomes. By comparing the total market value of a nations production.

Principle #9: Prices Rise When the Government Prints Too Much Money. Inflation is an increase in the overall level of prices in the economy. One cause of inflation is the growth in the quantity of money. When the government creates large quantities of money, the value of the money falls.

Principle #10: Society Faces a Short-run Trade-off between Inflation and Unemployment. The Phillips Curve illustrates the trade-off between inflation and unemployment: Short-run effects of monetary injection: Increasing amount of money in the economy stimulates the overall level of spending and thus the demands for goods and services. Higher demand causing the firms to raise their prices, but in the mean time they also increase the quantity of goods and services they produce and also hire more workers to produce those goods and services. More hiring means lower unemployment. [on the other side this policy also cause inflation]

Inflation or Unemployment Its a short-run trade-off!

The trade-off plays a key role in the analysis of the business cycle fluctuations in economic activity, such as employment and production

Short Summary The fundamental lessons about individual decision making are that people face tradeoffs among alternative goals, that the cost of any action is measured in terms of forgone opportunity, that rational people make decisions by comparing marginal cost and marginal benefits, and that people change their behavior in response to the incentive they face.

The fundamental lessons about interactions among people at\re that trade can be mutually beneficial, that market are usually a good way to coordinate trade among people, and that the governments can potentially improve market outcome if there is some market failure or if the market outcome is inequitable. The fundamental lessons about the economy as 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.