Chapter 1Ten 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

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 importantbecause resources are scarce.

Economics is the study of how society manages its scarce resources.…how people make decisions....how people interact with each other.…the forces and trends that affect the economy as a whole.

What is Economics?

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

Food vs. Clothing

Leisure Time vs. Work

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 means one more.

– Would you consumer one more apple?

– 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

When your marginal cost or benefit from a decision changes, that can change your decision.

– 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 ?

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 trading 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 bfirms determine what to buy, who to work for, who to hire and what to produce.

Interaction between households and firms is guided by prices (“invisible hand”). They look at prices when deciding what to buy and sell.

Puzzle: Although everybody is guided by his/her own self- interest and 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.

Causes of Market Failure

1) Externality: impact of one person’s actions on the well-being of a bystander.

– when you slow down on a highway to have a look at an accident, you don’t care if that causes traffic jam behind you.  

– Other Examples: Pollution, Research

2) Market Power is the ability of a single person or a small group to unduly influence market prices. Examples: monopoly, Cartel.

3) Asymmetric Information: one party (seller or buyer) having more information than the other about a product. Examples: In the auto insurance market, drivers know whether they are careful drivers, but ICBC does not.

In the used car market, who has more information (on the condition of the car)?

Causes of Market Failure

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 depends on per capita income, not total income of the country.– Canada’s living standard is higher than that

of China (although China’s GDP is close to 3 times higher than Canada’s)

– Differences in standard of living between countries is attributable to the productivity.

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 over supply of money (notes and coins). This reduces the value of money.

– Germany (Jan 1921), Price of a daily newspaper was 0.3 mark. By Nov 1922, the price was 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

When govt. reduces the quantity of money, in the long run, prices go down. But in the short run, prices remain the same. It takes time for the stores to change their prices and restaurants to change their menu etc (sticky prices).

InflationInflation UnemploymentUnemployment

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

With less money and unchanged prices, people will buy less. As consumers buy less, producers produce less and employ less people, causing unemployment.

The central bank (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 (such as TD, RBC and BMO) or the public.