Ten Principles of Economics

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Chapter 1
Ten Principles of Economics ECON 101 Ratna K.
Shrestha
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Overview

• Scarcity and Economics
• How People Make Decisions
• How People Interact
• How the Economy as a Whole Works

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Decisions

• Who will work?
• What good and how many to produce?
• What resources to use?
• Who will we sell it to and at what price?

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Scarcity...

• means that society has less to offer than
  people wish to have.
• Managing societys resources is important
• because resources are scarce.

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Economics is the study of how society manages its
scarce resources
What is Economics?

• Economists study. . .
• how people make decisions.
• ...how people interact with each other.
• the forces and trends that affect the economy as
  a whole.

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How People Make Decisions?

• People face tradeoffs.
• The cost of something is what you
• give up to get it.
• Rational people think at the margin.
• People respond to incentives.

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1. People face tradeoffs

• To get one thing, we usually have to
• give up another thing

(a) Guns vs. Butter (b) Food vs. Clothing (c)
Leisure Time vs. Work (d) Efficiency vs. Equity
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1. People face tradeoffs

• Efficiency means . . .
• getting the most you can from scarce resources.
• Equity means . . .
• benefits of resources are distributed fairly
  among society.

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2. The Cost of Something Is What You Give Up to
Get It

• Decisions require comparing costs and benefits of
  alternatives
• Going to university vs. going to work
• Opportunity Cost is what you give up from one
  alternative (choice) to get what you want (from
  another choice)
• What is the opportunity cost of going to
  university for Hokey Star Joe Sakic?
• What is the Opportunity Cost of Econ 101?

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3. Rational People Think at the Margin

• Marginal changes are small, incremental
  adjustments to an existing plan of action.
• Comparing extra benefits and costs of a critical
  choice such as whether to get a masters degree
  or attend one more year of University.
• Your decision depends on
• Marginal Benefits MB
• Marginal Costs MC of such a choice.
• What are the MB and MC of a MA degree?

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4. People Respond to Incentives

• Marginal changes in costs or benefits from
  decisions motivate people to respond.
• What would you do if the government imposes a tax
  of 1/lit on gasoline?
• Fertility rate went up in Quebec between
  1988-1997 in response to baby bonus. Should the
  bonus be higher for the first or second baby ?
• Decision to choose one good over another occurs
  when MB MC.

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4. People respond to incentives.

• LA Laker basketball star Kobe Bryant chose to
  skip college and go straight to the NBA from high
  school when offered a 10 million contract.

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How People Interact?

• Trade can make everyone better off.
• Markets are usually a good way to organize
  economic activity.
• Government can sometimes improve market outcomes.

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5. Trade Can Make Everyone Better Off

• Individuals gain from their ability to trade with
  others. You cannot grow your own food, make your
  own clothes, and build your own homes.
• Trade allows one to specialize in what he/she
  does best and enjoy a greater variety of goods.
• What does Canada specialize in and what does
  Canada buy from others?

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6. Markets Are Usually a Good Way to Organize
Economic Activity

• In a Market Economy, households and business
  firms determine what to buy, who to work for, who
  to hire and what to produce.
• Interaction between household and business is as
  if guided by an invisible hand. Households and
  firms look at prices when deciding what to buy
  and sell.
• The puzzle is that in a market economy everybody
  is guided by his/her own self- interest and yet
  it promotes overall economic well being.

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7. Governments Can Sometimes Improve Market
Outcomes

• Market failure results in inefficiency - failure
  of the invisible hand.
• When the market fails the government can
  intervene to promote Efficiency.
• Government also intervenes to promote Equity.
• Oftentimes both efficiency and equity are not
  obtainable simultaneously.

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7. Governments Can Sometimes Improve Market
Outcomes

• Causes of Market failure
• Externality, impact of one persons actions on
  the well-being of a bystander.
• Example Freeway accidents, even if they're off
  on the side of the road, usually cause traffic
  jams.  These jams occur because drivers don't
  take the external cost of their actions (on other
  drivers) into account when they slow down to take
  a look. 
• Other Examples Pollution, Research, etc..

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7. Governments Can Sometimes Improve Market
Outcomes

• Market power is the ability of a single person or
  a small group to unduly influence market prices.
  (examples monopoly, Cartel)
• Asymmetric information, a situation where one
  party (seller or buyer) has more information than
  the other party about a product.
• ex In the auto insurance market, drivers have
  information about what kind of drivers (risky or
  careful) they are but ICBC does not. - In the
  used car market who has the information about the
  condition of the car?

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7. Governments Can Sometimes Improve Market
Outcomes

• How can the government improve market outcomes?
• Government can tax or subsidize externality
  creating activities. For example, Tax pollution,
  subsidize research.
• Government can control prices, prevent firms from
  collusion, or break a big company into smaller
  firms to foster competition. US government split
  ATT into smaller baby bells to foster
  competition in mid 1970s.

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How the Economy as a Whole Works?

• A countrys standard of living depends on its
  ability to produce goods and services.
• Prices rise when the government prints too much
  money.
• Society faces a short-run tradeoff between
  inflation and unemployment.

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8. Standard of living depends on a countrys
production.

• Standard of Living may be measured in different
  ways (e.g. personal income or total market value
  of a nations production.)
• Differences in standard of living between
  countries or even provinces is attributable to
  the productivity of the country or province.
• Why Canadas average per capita income 28,000
  while that of Mexico 12,000?
• - Standard of living depends on per capita
  income, not total income of the country.

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8. Standard of living depends on a countrys
production.

• Productivity is the amount of goods and services
  produced from each hour of a workers time.
• Higher the Productivity, higher the Standard of
  Living.
• So when thinking about how a public policy will
  affect living standards, the key question is how
  it affects our ability to produce goods and
  services.

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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. This reduces the value of
  money.
• In Germany in Jan 1921, a daily newspaper cost
  0.3 mark. In Nov 1922, the same newspaper cost
  70,000,000 mark, why?
• The high inflation in 1970s in Canada was also
  associated with oversupply of money.

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• Inflation rate in Zimbabwe topped 2.2 million
  percent in 2008.

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10. Society Faces a Short-Run Tradeoff Between
Inflation and Unemployment
Inflation
Unemployment

• This short-run tradeoff is called the Phillips
  Curve.
• When govt. reduces the quantity of money, in the
  long run, prices go down.
• But in the short run prices are sticky and it
  reduces the amount people can spend. This in turn
  causes unemployment.

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10. Society Faces a Short-Run Tradeoff Between
Inflation and Unemployment

• The central bank (for example, the bank of
  Canada) can increase money supply by printing
  more notes and coins and using these notes and
  coin to buy government bonds from the commercial
  banks or the public.
• It can reduce the money supply by selling bonds.
• With the decrease in money supply, the value of
  money goes up in the long run (i.e., prices go
  down) but in the short run, prices remain the
  same.
• With less money and unchanged prices, people will
  buy less. As consumers buy less, producers
  produce less and employ less people.