Download Ten Principles of Economics

Chapter 1
Ten Principles of
Economics
Microeconomics
Ratna K. Shrestha
Overview
Scarcity and Economics
 How People Make Decisions
 How People Interact
 How the Economy as a Whole Works

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?
Scarcity...
… means that society has less to offer than
people wish to have.
Managing society’s resources is important
because resources are scarce.
What is Economics?
Economics is the study of how society
manages its scarce resources

Economists study. . .
…how people make decisions.
...how people interact with each other.
…the forces and trends that affect the
economy as a whole.
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.
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
1. People face tradeoffs

Efficiency means . . .
…getting the most you can from scarce
resources.

Equity means . . .
…benefits of resources are distributed fairly
among society.
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 310?

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
master’s 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?
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.
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.
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.

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?
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 selfinterest and yet it promotes overall economic
well being.
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.
7. Governments Can Sometimes Improve
Market Outcomes

Causes of Market failure
– Externality, impact of one person’s 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..
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?
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 AT&T into smaller “baby
bells” to foster competition in mid 1970s.
How the Economy as a Whole Works?
A country’s 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.

8. Standard of living depends on a
country’s production.

Standard of Living may be measured in different
ways (e.g. personal income or total market value
of a nation’s production.)
– Differences in standard of living between
countries or even provinces is attributable to
the productivity of the country or province.
– Why Canada’s 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.
8. Standard of living depends on a
country’s production.



Productivity is the amount of goods and
services produced from each hour of a worker’s
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.
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 1970’s in Canada was
also associated with oversupply of money.

Inflation rate in Zimbabwe topped
2.2 million percent in 2008.
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.
10. Society Faces a Short-Run Tradeoff
Between Inflation and Unemployment


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.
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.