3. Ten principles of economics
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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
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 Market Outcomes
How the Economy as a Whole Works
8: A Country’s 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
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4. Ten Principles of Economics
• Economy – “oikonomos” (Greek)
–“One who manages a household”
• Economy is composed of households and
firms
• Economics is the study of how households
and firms make decisions under scarcity
–Scarcity – all resources are scarce (finite)
• Decisions about how to use them implies
tradeoffs are involved
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5. The circular flow
1
5
This diagram is a
schematic representation
of the organization of the
economy. Decisions are
made by households and
firms. Households and
firms interact in the
markets for goods and
services (where
households are buyers and
firms are sellers) and in the
markets for the factors of
production (where firms are
buyers and households are
sellers). The outer set of
arrows shows the flow of
dollars, and the inner set of
arrows shows the
corresponding flow of
inputs and outputs.
6. Ten Principles of Economics
• Scarcity - limited nature of society’s resources
• Economics
–Study of how society manages its scarce
resources
• Economists study:
–How people make decisions
–How people interact with one another
–Analyze forces and trends that affect the
economy as a whole
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7. How People Make Decisions
Principle 1: People face trade-offs
• Making decisions
–Trade off one goal against another
–Society
• National defense vs. consumer goods
• Clean environment vs. high level of income
• Efficiency vs. equality
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8. How People Make Decisions
Principle 1: People face trade-offs
• Efficiency
–Society - maximum benefits from its scarce
resources
–Size of the economic pie
• Equality
–Benefits - uniformly distributed among
society’s members
–How the pie is divided into individual slices
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9. The production possibilities frontier
2
9
Quantity of
Computers
Produced
Quantity of
Cars
Produced
0 300 600 700 1,000
3,000
A
B
C
D
E
F
1,000
2,200
2,000
Production
Possibilities
Frontier
The production possibilities
frontier shows the
combinations of output - in
this case, cars and
computers - that the
economy can possibly
produce.
The economy can produce
any combination on or
inside the frontier.
Points outside the frontier
are not feasible given the
economy’s resources.
10. The Economist as a Scientist
• Efficient levels of production
–Economy’s getting all it can
• From the scarce resources available
–Points on the production possibilities frontier
–Trade-off:
• The only way to get more of one good
• Is to get less of the other good
• Inefficient levels of production
–Points inside production possibilities frontier
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11. How People Make Decisions
Principle 2: The cost of something is what you
give up to get it
• People face trade-offs
–Make decisions
• Compare cost with benefits of alternatives
–Opportunity cost
• Whatever most be given up to obtain one item
• PPF – Opportunity cost is what you give up as you
produce more of another good
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12. How People Make Decisions
Principle 3: Rational people think at the margin
• Rational people
–Systematically & purposefully do the best
they can to achieve their objectives
• Marginal changes
–Small incremental adjustments to a plan of
action
• Rational decision maker – take action only if
–Marginal benefits > Marginal costs
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13. How People Make Decisions
Principle 4: People respond to incentives
• Incentive
–Something that induces a person to act
–Higher price
• Buyers - consume less
• Sellers - produce more
–Public policy
• Change costs or benefits
• Change people’s behavior
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14. Incentives for Firms
• First Law of Supply:
• the higher the market price the greater the
quantity supplied by each firm
15. Incentives - Consumers
• First Law of Demand
– The higher the price, the lower is quantity
demanded
16. Can Economic Incentives Get You
Pregnant?
• http://freakonomics.blogs.nytimes.com/2008/01/16/can-economic-incentives-get-
you-pregnant/
• Can fertility rates be linked to financial incentives (or disincentives) to have
children? Alma Cohen, Rajeev Dehejia, and Dmitri Romanov, “Do Financial
Incentives Affect Fertility?”
– We find a significant positive effect on fertility, with the mean level of child
subsidies producing a 7.8 percent increase in fertility.
– we find that a large, unanticipated reduction in child subsidies that
occurred in 2003 had a substantial negative impact on fertility.
– Overall, our results support that fertility responds to financial
incentives and indicate that the child subsidy policies used in many
countries can have a significant influence on incremental fertility
decisions.
17. How People Interact
Principle 5: Trade can make everyone better off
• Trade
–Specialization
• Allows each person/country to specialize in the
activities he/she does best
–People/countries can buy a greater variety of
goods and services at lower cost
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18. How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Communist countries – central planning
–Government officials (central planners)
• Allocate economy’s scarce resources
– Decided
» What goods & services were produced
» How much was produced
» Who produced & consumed these goods & services
• Theory: only the government could organize
economic activity to promote economic well-
being for the country as a whole 18
19. How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Market economy - allocates resources
–Decentralized decisions of many firms and
households
–As they interact in markets for goods and
services
–Guided by prices and self interest
–Adam Smith’s “invisible hand”
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20. How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• We need government
–Enforce the rules
–Maintain institutions - key to market economy
• Enforce property rights
• Property rights
–Ability of an individual to own and exercise
control over scarce resources
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21. How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• Government intervention
–Change allocation of resources
–To promote efficiency
• Avoid market failure
–To promote equality
• Avoid disparities in economic wellbeing
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22. How People Interact
• Market failure
–Situation in which the market on its own fails
to produce an efficient allocation of resources
• Causes for market failure
–Externality
• Impact of one person’s actions on the well-being
of a bystander
–Market power
• Ability of a single person (or small group) to
unduly influence market prices
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23. How People Interact
• Disparities in economic wellbeing
–Market economy
• Rewards people - ability to produce things that
other people are willing to pay for
–Government intervention
• Public policies
– May diminish inequality
– Process far from perfect
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