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 member’s
abilities, efforts, and desire. This explanation also goes for the society.
- Society and Scarce Resources:
- The management of society’s 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
- People face trade-offs.
- The cost of something is what you give up to get it.
- Rational people think at the margin.
- 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 alternative’s marginal
benefits exceed its marginal costs!
HOW PEOPLE INTERACT
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 don’t 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 firm’s actions on the well-being 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
Principle #8: A
Country’s 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 worker’s time.
•
Standard of
living may be measured in different ways:
•
By comparing
personal incomes.
•
By comparing the
total market value of a nation’s 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
•
It’s 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
Source : Principles of Economics, N. Gregory Mankiw
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