2012 Spring
Notes Ch 1 & 2 from book: Principles of Microeconomics
Gregory Mankiw 6th Ed.Ch1: Ten Principles of Economics Resources
are scarce Scarcity: The limited nature of societys nature Society
has limited resources and therefore cannot produce all the goods
and services people wish to have. Economics: the study of how
society manages its scarce resources. through combined actions of
millions of households and firms. Economics study how people make
decisions on how to allocate their scarce resources.The 10
principles outline:How People Make Decisions1. People face
trade-offs2. The cost of something is what you give up to get it3.
Rational people think at the margin4. People respond to
incentivesHow People Interact5. Trade can make everyone better
off6. Markets are usualy a good way to organize economic activity7.
Governments can sometimes improve market outcomesHow the economy as
a whole works8. A countrys standard of living depends on its
ability to produce goods and services9. Prices rise when the
government prints too much money10. Society faces a short-run
trade-off between inflation and unemploymentPrinciple 1: People
Face Trade-offs1. Making decisions requires trading off one goal
against another.a. To get one thing we like, we usually have to
give up another thing we like.2. Examples of trade-offsa. Ex. guns
and butteri. Society spends on national defense (guns) to protect
its shroes from foreign aggressorsii. By doing this though, one
spends less on consumer goods (butter) to raise the standard of
living at home. 3. Ex. 2: clean environment and high level of
incomea. Increasing expenses on trying to cut down pollution
reduces profits. 4. Ex. 3: Efficiency vs. equalitya. Efficiency:
when society is getting the maximum benefits from its scarce
resources. b. Equality: when the economic prosperity/benefits are
distributed uniformly among societys members. c. Greater equality
reduces efficiency. i. People would work less and produce fewer
goods and services if gov redistributes income form the rich to the
poor. d. Ex. Government trade-offi. when you increase tax for the
rich, efficiency goes down because they have less incentive for
work. ii. But for equality, because we have increased the income
tax of the rich, and government can use these taxes for government
distribution of Money to poor, equality goes up. e. Ex. Company
trade-offi. Profit= return-costii. Want to maximize profit, you
either need to increase return or reduce costf. Ex. individuali.
Education OR cost/time5. Conclusion: people are likely to make good
decisions only if they understand the options they have available.
Study of economics therefore starts by acknowledging lifes
trade-offs.Principle 2: The Cost of something is what you give up
to get it: Opportunity Cost1. Because we make trade-offs, making
decisions requires comparing the costs and benefits of alternative
courses of action. 2. Opportunity cost= highest loss3. Example:
Cost of going to college. a. What is the cost?i. Wed be tempted
just to add up the money we spend on tuition, books, room and
board. 1. 2 problems with this calculationa. Includes some things
that are not really costs of going to college. i. Even if we dont
go to schoo, we need a place to sleep and food to eat.b. This
calculation ignores the largest cost of going to college= our
time4. Opportunity Cost= what you give up to get that item.
Principle 3: Rational People Think at the Margin1. Economists
normally assume people are rationala. Rational people=people who
systematically and purposefully do the best they can to achieve
their objectives, given the available opportunities. 2. Rational
people think at the margin: they make decisions comparing marginal
benefits and marginal costs. a. Marginal change= small incremental
adjustment to an existing plan of action. i. Margin= edgeii.
Marginal change= adjustments around the edges of what you are
doing. 3. When company wants to maximize profit, we consider the
marginal return vs. marginal cost. a. If MR> MC more profiti.
MR= if you increase one unit of this one product, how much more you
get. ii. MC= if you increase one unit of a product how much more
you have to spend. 4. Example of making a decision thinking of
marginal costsa. An ariline is deciding how to charge passengers
who fly standbyi. Flying a 200-seat plane across US costs
$100,000ii. The average cost of each seat is therefore
$100,000/200= $500b. From this, one may be tempted to say that one
should NEVER sell a ticket under $500c. But, if a standby passenger
is waiting at the gate and will pay $300 for a seat, should the
airline sell the ticket?i. Yes! Because the marginal cost of adding
one more passenger in empty seats is merely the cost of a bag of
peanuts and soda that passenger will consume. d. As long as the
standby passenger pays more than the marginal cost, selling the
ticket is profitable. 5. Example of making a decision thinking of
marginal benefit. a. Why is water so cheap, while diamonds so
expensive?b. Wateri. Humans need water to survive, but the marginal
benefit of an extra cup is small since water is plentiful. c.
Diamondi. Diamonds are not essential, but the marginal benefit of
an extra diamond is considered to be large. Principle 4: People
Respond to Incentives1. Incentive= something that induces a person
to actsuch as the prospect of a punishment or reward. 2. Incentives
are crucial to analyzing how markets workincentives influence the
behavior of consumers and producers which is crucial for how a
market economy allocates its resourcesa. Ex. When apple prices
increase, people buy/eat less apples. b. But at the same time,
apple orchards decide to produce more apples hire more workers
harvest more apples. c. Higher prices in a market provide an
incentive for buyers to consume less and for sellers to produce
more. 3. Public policymakers have a strong influence in a market as
they can control incentivesa. Ex. tax on gasoline encourages people
to drive smaller, more fuel-efficient cars. Which then again
influences car producers. 4. Price is high, demand of consumer
decrease, and supplier/firm increases. 5. Interesting twist to
incentives: the seatbelt casea. 50 years ago, not all cars had
seatbelts. It wasnt enforced by law. i. No seatbelts= incentive to
drive slower, drive more safely/carefully. ii. Result: fewer
accidents, more deaths caused by accidents.b. After enforcing the
seat belt lawi. With seatbelts= incentive to drive faster, less
carefullyii. Result: larger number of accidentsboth between cars
and with pedestrian accidents. c. Net result: little changethese
laws produced both fewer deaths per accident and more accidents. 6.
Another example of incentives: increase in gasoline prices from
2005-2008a. b/c of this increase in gas price, people looked for
alternatives. i. Smaller calls, scooters, bicycles, more online
courses, less personal jetsb. Economic downturn that began in 2008
and continued into 2009 reduced world demand for oil price of gas
declined substantially7. Tax increase, incentive decreases;
decrease in tax, incentive increases. Principle 5: Trade Can Make
Everyone Better Off1. Trade between 2 countries can make each
country better offa. Because two countries are in competition does
not mean that trade is unfavorable. 2. Trade allows each person to
specialize in the activities he/she does best. 3. By trading,
people can buy a greater variety of goods&services at lower
cost. Principle 6: Markets are Usually a Good Way to Organize
Economic Activity1. Market economy: an economy that allocates
resources through the decentralized decisions of many firms and
households as they interact in markets for goods and services. a.
Firms decide whom to hire and what to makeb. Households decide
which firm to work for and what to buy c. Firms & Households
interact in the marketplace, where they are guided by prices and
self-interest. 2. In market economy, no one is looking out for the
well-being of the society as a whole. a. Buyers and sellers are
interested primarily in their own well-being. 3. Adam Smith, An
Inquiry into the Nature and Causes of the Wealth of Nations:
Households and firms interact in markets as if they are guided by
an invisible hand that leads them to desirable market outcomes. a.
Prices= the instrument with which the invisible hand directs
economics activity1. Price determines:1. how much to demand (buy)2.
How much to supply (produce)2. So, price reflects both the value of
a good to a society (demands) and the cost to society of making the
good (supply)3. Prices adjust to guide these buyers and sellers to
reach outcomes that most of the ties maximize the well-being of
society as a whole. 4. When gov. prevents prices form adjusting
naturally to supply and demand, it prevents the invisible hand to
do its work of maximizing well-being of firms and households. a.
Ex. taxes, rent control5. Market ForceSupply
Equilibriumbest price
Demand
Principle 7: Governments Can Sometimes Improve Market Outcomes1.
If invisible hand can do all the work to maintain a healthy market,
why do we need a government??2. Reason 1a. = the invisible hand can
work its magic only if (1) the government enforces the rules and
(2) maintains the institutions that are key to a market economy. b.
(1) gov needs to enforce the rulesi. Most importantly, gov needs to
enforce property rights so individuals can own and control scare
resources. 1. Property rights= the ability of an individual to own
and exercise control over scarce resources. ii. We all rely on
police and courts to enforce our rights over the things we produce.
1. Ex. a farmer wouldnt grow crops if he knew theyd be stolen2.
Restaurants wouldnt serve meals if customers dont pay3. Company
wouldnt produce DVDs if customers can avoid paying by making
illegal copies3. Reason 2a. = the invisible hand is powerful but it
is not omnipotent. We need a gov to promote efficiency and promote
equalityi. Market failure: a situation in which the market on its
own fails to produce an efficient allocation of resources.ii.
Possible causes of market failure:1. Externality: impact of one
persons actions on the well-being of a bystandera. Ex. pollution2.
Market power: ability of a single person/small group to unduly
influence market prices4. Reason 3a. =market economy/invisible hand
yields efficient outcomes most of the times but still can lead to
unequal economic well-being. b. Inequality because market economy
rewards ppl according to their ability to produce things that will
attract people to pay for them. c. Government/public policies aid
to equalize these disparities. i. Ex. income tax, welfare
system..Principle 8: A Countrys Standard of Living Depends on Its
Ability to Produce Goods and Services1. There are huge differences
in the standard of living around the world. 2. These living
standards change over time, and these changes are largea. Over the
past century, average US income rose ~x83. What explains these
large diff in living standards among countries and over time?a.
Differences in productivity: the amount of goods and sercices
produced from each unit of labor input. 4. The growth rate of a
nations productivity determines the growth rate of its average
income. 5. Policymakers can boost living standards by improving
education and other tools needed to improve productivity. Principle
9: Prices rise when the government prints too much money1.
Inflation= an increase in the overall prices in the economy. 2. Why
inflation?a. Government prints out too much moneyvalue of the money
falls prices increasePrinciple 10: Society Faces a Short-Run
Trade-off between Inflation and Unemployment1. Cause: increasing
quantity of money Effect: increasing level of prices 2. Other
short-run effects:a. Printing out more money stimulates overall
level of spending increases demands for goods&services firms
raise their prices hire more workers to produce larger quantity of
goods&services lower unemployment3. Conclusion: gradually,
inflation increases, unemployment decreases4. These short-run
trade-offs play a critical role in the analysis of the business
cyclea. Business cycle: fluctuations in economic activity, such as
employment and production. 5. Government has lots of power. a. By
changing the amount gov spends, amount it taxes, amount of money it
prints, they can influence theoverall demand for good and
service.s6. Example: When President Obama came to presidency in
2008-2009 when US was facing a deep economic downturna. Obama
reduced taxes and increased gov spendingb. Federal Reserve
increased the supply of moneyc. = goal: reduce unemploymentd. But
ppl worried about inflation. Ch2: Thinking Like an EconomistWhat is
distinctive about how economists confront a question? What does it
mean to think like an economist?Economist as a Scientist Economics
is a science Uses the scientific method Economists devise theories,
collect data, analyze them and try to verify/refute their
theoriesThe Scientific Method: Observation, Theory, and More
Observation1. Interplay between theory and observation occurs in
economicsa. Ex. if someone sees prices increasing in a country and
devises the theory of inflationb. They test to see if there is
strong correlation between money growth and inflation. 2.
Experimenting in economics is difficult/sometimes impossiblea. Ex.
in case of inflation, hard because economists cannot manipulate a
nations monetary policy just to generate useful data. 3.
Experiments are offered by historyThe Role of Assumptions1.
Assumptions can simplify the world and make it easier to
understanda. Ex. by assuming 2 countries w/ 2 goods, we can focus
our thinking on the essence of the problem2. Economists use
different assumptions for different experiments/questionsa. Ex.
Economists use different assumptions when studying short-run and
long-run effects of a change in the quantity of money. Economics
Models Economists use models to learn about the world Models are
built with assumptionsOur First Model: The Circular-Flow
Diagram
1. Circular-flow diagram: model of economy that shows how
dollars flow through markets among households and firms2.
Assumptions:a. 2 types of decision makers:i. Firmsii. Households3.
How it works:a. Firms produce goods/services using inputs /factors
of production (labor, land, capital) from householdsb. Then
households consume those goods/servicesOur Second Model: The
Production Possibilities Frontier1. Production Possibilities
Frontier: graph that shows the combinations of output that the
economy can possibly produce a. given the available factors of
production and b. the available production technology. 2. Our Model
Assumptions:a. Only 2 goods- cars & computersb. Car industry
and computers industry together use all of economys factors of
production
3. Efficienta. A & B & F & Eb. Efficiency means that
you cannot gain something without sarifiing the otherc. So every
point on the PPF line will be efficient4. Inefficienta. D5. Out of
production possibilitya. Cb. Because of limited factors of
production of the country , it is not possible to reach point C6.
Only way to get out of the PPFa. Things life technological
advancesb. TRADEHow to calculate the opportunity cost of a country
Slope of the tangent line to the point of production on the PPF is
the opportunity cost.
