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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?
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© 2009 South-Western, a part of Cengage Learning, all rights reserved
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What Economics Is All About
The principles of
HOW PEOPLE
MAKE DECISIONS
 Scarcity: the limited nature of society’s
resources
 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
 Spending on Cloth/Food vs Vacation
 Guns vs Butter
leaves less time for studying.
 Having more money to buy stuff requires working
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
What You Give Up to Get It
 Society faces an important tradeoff:
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
 It is the relevant cost for decision making.
 Tradeoff: To achieve greater equality,
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
What You Give Up to Get It
Principle #3: Rational People Think at the
Margin
Examples:
The opportunity cost of…
Rational people
 systematically and purposefully do the best they
can to achieve their objectives.
…going to college for a year is not just the tuition,
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,
but the value of the time you spend in the theater.
of marginal changes – incremental adjustments
to an existing plan.
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HOW PEOPLE MAKE DECISIONS
HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
Principle #3: Rational People Think at the
Margin
Examples:
Examples:
 When a student considers whether to go to
 Diamond-water paradox
 An airline taking an extra passenger when the
college for an additional year, he compares the
fees & foregone wages to the extra income
he could earn with the extra year of education.
flight isn’t full
 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
already spent $1000 on repairs.
act, i.e. the prospect of a reward or punishment.
At the last minute, the transmission dies. You can
pay $600 to have it repaired, or sell the car “as is.”
 Rational people respond to incentives.
Examples:
 When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
 When cigarette taxes increase,
teen smoking falls.
In each of the following scenarios, should you
have the transmission repaired? Explain.
A. Blue book value is $6500 if transmission works,
$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
Cost of fixing transmission = $600
Observations:
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
 The $1000 you previously spent on repairs is
Answers
Answers
irrelevant. What matters is the cost and benefit
of the marginal repair (the transmission).
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
 The change in incentives from scenario A
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
HOW PEOPLE
INTERACT
Principle #5: Trade Can Make Everyone
Better Off
 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 that
could be produced at home
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HOW PEOPLE INTERACT
HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
 A market economy allocates resources through
 Market: a group of buyers and sellers
the decentralized decisions of many households
and firms as they interact in markets.
(need not be in a single location)
 “Organize economic activity” means determining
 what goods to produce
 how to produce them
 how much of each to produce
 who gets them
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 Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.
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HOW PEOPLE INTERACT
HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
Principle #6: Markets Are Usually A Good Way
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
Improve Market Outcomes
Principle #7: Governments Can Sometimes
Improve Market Outcomes
 Important role for govt: enforce property rights
 Market failure: when the market fails to allocate
society’s resources efficiently
(with police, courts)
 Causes:
 People are less inclined to work, produce, invest,
 Externalities, when the production or consumption
or purchase if large risk of their property being
stolen.
 A restaurant won’t serve meals if customers do not
pay before they leave.
 A music company won’t produce CDs if too many
people avoid paying by making illegal copies.
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of a good affects bystanders (e.g. pollution)
 Market power, a single buyer or seller has
substantial influence on market price (e.g. monopoly)
 In such cases, public policy may promote efficiency.
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HOW PEOPLE INTERACT
ACTIVE LEARNING 2
Discussion Questions
Principle #7: Governments Can Sometimes
Improve Market Outcomes
In each of the following situations, what is the
government’s role? Does the government’s
intervention improve the outcome?
 Govt may alter market outcome to promote equity
 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.
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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
HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.
 Huge variation in living standards across
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
depends on its ability to produce goods &
services.
Principle #9: Prices rise when the
government prints too much money.
 Inflation: increases in the general level of prices.
 In the long run, inflation is almost always caused by
 The most important determinant of living standards:
productivity, the amount of goods and services
produced per unit of labor.
excessive growth in the quantity of money, which
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
tradeoff between inflation and unemployment
Principle #10: Society faces a short-run
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
unemployment in opposite directions.
monetary injections as follows:
 Higher demand may over time cause firms to
raise their prices, but in the meantime, it also
encourages them to hire more workers and
produce a larger quantity of goods and services.
 More hiring means lower unemployment.
 Most economists describe the short-run effects of
monetary injections as follows:
 Increasing the amount of money in the economy
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 family deciding whether to buy a new car
 a member of Parliament deciding how much to
spend on national parks
 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
a choice between spending the money now and
putting it away for a year in a bank account that
pays 5 percent interest. What is the opportunity
cost of spending the Tk 10,000 now?
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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
efficiency. In the case of efficiency, discuss the type of market
failure involved.
 a. regulating cable TV prices
 b. providing some poor people with vouchers that can be
used to buy food
 c. prohibiting smoking in public places
 d. breaking up Standard Oil (which once owned 90 percent
of all U.S. oil refineries) into several smaller companies
 e. imposing higher personal income tax rates on people
with higher incomes
 f. enacting laws against driving while intoxicated
5 million in developing a new product, but the
development is not quite finished. At a recent
meeting, your salespeople report that the
introduction of competing products has reduced
the expected sales of your new product to Tk 3
million.
 If it would cost Tk 1 million to finish development
and make the product, should you go ahead and
do so?
 What is the most that you should pay to
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.
 a. “Everyone in society should be guaranteed
the best healthcare possible.”
 b. “When workers are laid off, they should be
able to collect unemployment benefits until they
find a new job.”
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antipoverty programs limited many welfare
recipients to only 2 years of benefits.
a. How does this change affect the incentives
for working?
b. How might this change represent a tradeoff between equality and efficiency?
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HOW THE ECONOMY AS A WHOLE WORKS
Thank You!
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