Microeconomics Chapter 1 Answers – Flashcards

The study of how human beings COORDINATE their WANTS and DESIRES, given the decision making mechanisms, social customs, and political realities of the society

In ECONOMICS, coordination refers to how the 3 CENTRAL PROBLEMS facing any economy are solved: 1. What, and how much, to produce 2. How to produce it 3. For whom to produce it

The goods available are too few to satisfy individuals' desires When goods are scarce, the goods MUST BE RATIONED

2 ELEMENTS OF SCARCITY 1. Our Wants 2. Our Means of Fulfilling those wants For example: -If you work on Wall Street, you probably want upscale and trendy clothes. -In Vermont, denim jeans and a flannel will do.

In all known economies, COORDINATION has involved some type of COERCION: 1. Limiting people's wants 2. Increasing the amount of work individuals are willing to do to fulfill those wants.

MICROECONOMIC THEORY - The study of how INDIVIDUAL CHOICE is influenced by economic forces Microeconomics studies such things as: 1. The pricing policies of firms 2. Households' decisions on what to buy 3. How markets allocate resources among alternative ends -------------------------------------------------------------------------------- MACROECONOMIC THEORY - The study of the ECONOMY AS A WHOLE Macroeconomics studies things such as: 1. Growth 2. Business Cycles 3. Unemployment 4. Inflation Macroeconomics focuses on AGGREGATE RELATIONSHIPS such as: -How household consumption is related to income -How government policies can affect growth

Making decisions on the basis of COSTS and BENEFITS Economic Reasoning is based on the premise that everything has a cost

For Example: •Saving some people's lives with liver transplants might not be worth the additional cost. The money might be better spent on nutritional programs that would save 20 lives for every 2 lives you might save with transplants. • Maybe we shouldn't try to eliminate all pollution because the additional cost of doing so may be too high. To eliminate all pollution might be to forgo too much of some other worthwhile activity. • Providing a guaranteed job for every person who wants one might not be a worthwhile policy goal if it means that doing so will reduce the ability of an economy to adapt to new technologies. • It might make sense for the automobile industry to save $12 per car by not installing a safety device, even though without the safety device some people will be killed.

Levitt's model is simple - People do what is in their BEST INTEREST FINANCIALLY - An example of "Thinking like a modern economist" in action

TANSTAAFL There Ain't No Such Thing As A Free Lunch

The additional cost to you over and above the costs you have already incurred

Costs that have already been incurred and cannot be recovered EXAMPLE: Consider attending class. You've already paid your tuition. It is a SUNK COST. So the marginal (additional) cost of going to class does not include tuition.

The additional benefit above what you've already derived EXAMPLE: The MARGINAL BENEFIT of reading the chapter is the additional knowledge you get from reading it. If you already knew everything in the chapter before even picking up the book, the marginal benefit of reading it is now ZERO.

If the Marginal Benefits > Marginal Costs, "DO IT" If the Marginal Costs > Marginal Benefits, "DON'T DO IT" EXAMPLE: -A girl says that she values her time at $75/hour (Marginal Cost). She estimates the Marginal Benefit of attending class to be $50. The Marginal Cost > Marginal Benefit, so she DOES NOT ATTEND CLASS. -The teacher tells her that he gives a quiz every week, and that students that miss the quizzes fail the course. Thus, she is UNDERESTIMATING the MARGINAL BENEFITS of attending the classes. Correctly estimated, the marginal benefits > marginal costs. So she SHOULD ATTEND CLASS

The value of the NEXT BEST ALTERNATIVE -------------------------- Opportunity Cost -------------------------- --->To obtain something, you must give up (forgo) something (the next best alternative) --->Opportunity Cost is the BASIS OF COST/BENEFIT ECONOMIC REASONING --->TANSTAAFL embodies opportunity cost because it tells us that there is a cost to everything; that cost is the next best forgone alternative

1. The opportunity cost of going out with the most beautiful woman in the world is the benefit you'd get from going out with your solid steady girl Margo 2. The opportunity cost of having a child might be 2 boats, 3 cars, and a 2 week vacation 3. The opportunity cost of taking a math course is that you may not be able to take a badminton course. 4. The opportunity cost of studying, is that you will have less time for sleep or exercise. 5. GUNS vs. BUTTER DEBATE -The opportunity cost of spending $50 Billion more on improving health care is $50 Billion not spent on helping the homeless, paying off debt, or providing for national defense

Adam Smith Thomas Malthus John Stuart Mill David Ricardo Karl Marx

All scarce goods must be rationed in some way. These rationing mechanisms are examples of ECONOMIC FORCES< the necessary reactions to scarcity

An Economic force that is given relatively free rein by society to work through the market Market Forces ration by "CHANGING PRICES" ------>When there's a SHORTAGE, the price goes UP. When there's a SURPLUS, the price goes DOWN.

The price mechanism (the rise and fall of prices) that guides our actions in a market.

Economic Reality is controlled by a contest among various forces: 1. Economic Forces (The Invisible Hand) 2. Social and Cultural/Historical Forces 3. Political and Legal Forces

The problem of getting a date for Saturday night. If a school has significantly more heterosexual people of one gender than the other, some men may well find themselves without a date—that is, men will be in EXCESS SUPPLY. An "excess supply" person could solve the problem by paying someone to go out with him or her, however, this is SOCIALLY UNACCEPTABLE. ------>This is an example of the complex social and cultural norms that guide and limit our activities. People don't try to buy dates because social forces prevent them from doing so.

Say you decide that you can make some money delivering mail in your neighborhood. You try to establish a small business, but suddenly you are confronted with the law. The U.S. Postal Service has a legal exclusive right to deliver regular mail, so you'll be prohibited from delivering regular mail in competition with the post office. -------->Economic forces, the desire to make money,led you to want to enter the business, but in this case political forces squash the invisible hand.

Consider a group of parents, all of whom want babies. Those who can, have a baby; those who can't have one, but want one, try to adopt. Adoption agencies ration the available babies. Who gets a baby depends on whom people know at the adoption agency and on the desires of the birth mother, who can often specify the socioeconomic background (and many other characteristics) of the family in which she wants her baby to grow up. That's the economic force in action; it gives more power to the supplier of something that's in short supply. If our society allowed individuals to buy and sell babies, that economic force would be translated into a market force. The invisible hand would see to it that the When an economic force operates through the market, it becomes a market force. Most people, including me, find the idea of selling babies repugnant. But why? It's the strength of social forces reinforced by political forces. One can think of hundreds of examples of such social and political forces overriding economic forces.

You don't practice medicine without a license; you don't sell body parts or certain addictive drugs. These actions are against the law. But many people do sell alcohol; that's not against the law if you have a permit. You don't charge your friends interest to borrow money (you'd lose friends); you don't charge your children for their food (parents are supposed to feed their children); many sports and media stars don't sell their autographs (some do, but many consider the practice tacky); you don't lower the wage you'll accept in order to take a job from someone else (you're no scab). You cannot understand economics without understanding the limitations that POLITICAL and SOCIAL FORCES place on economic actions.

A framework that places the generalized insights of the theory in a more specific contextual setting ------------------------------------------------------------------------------- Notes ------------------------------------------------------------------------------- Theories, models, and principles are continually "brought to the data" to see if the predictions of the model match the data. This has led to a stronger reliance on quantitative empirical methods in modern economics than in earlier economics.

A commonly held economic insight stated as a law or principle ------------------------------------------------------------------------------- Notes ------------------------------------------------------------------------------- Theories, models, and principles are continually "brought to the data" to see if the predictions of the model match the data. This has led to a stronger reliance on quantitative empirical methods in modern economics than in earlier economics.

A branch of economics that studies the economy through controlled laboratory experiments.

Naturally occurring events that approximate a controlled experiment where something has changed in one place but has not changed somewhere else. ------------------------------------------------------------------------------- For Example: ------------------------------------------------------------------------------- When New Jersey raised its minimum wage and neighboring state Pennsylvania did not. Economists Alan Kruger and David Card compared the effects on unemployment in both states and found that increases in the minimum wage in New Jersey did not significantly affect employment.

Propositions that are logically true based on the assumptions in a model ------------------------------------------------------------------------------- Notes ------------------------------------------------------------------------------- -MODELS lead to THEOREMS -Theories and Models are ABSTRACT -They rely on simplify- ing assumptions, and if you don't know the assumptions, you don't know the theory -Theories are a shorthand way of telling a story -These stories are important; they make the theory come alive and convey the insights that give economic theory its power.

Policy rules that conclude that a particular course of action is preferable ------------------------------------------------------------------------------- Notes ------------------------------------------------------------------------------- To arrive at policy precepts, theories, models, and principles must be combined with a knowledge of real- world economic institutions to arrive at specific policy recommendations. In discussing policy implications of theories and models, it is important to distinguish precepts from theorems.

Using these theorems, economists have developed the INVISIBLE HAND THEOREM. --->A market economy, through the price mechanism, will tend to allocate resources efficiently

A market economy, through the price mechanism, will tend to allocate resources efficiently

Achieving a goal as cheaply as possible

------------------------------------------------------------------------------- 1. Modern traditional economists ------------------------------------------------------------------------------- -Use models that focus on traditional assumptions of rationality and self-interest; ------------------------------------------------------------------------------- 2. Modern Behavioral Economists ------------------------------------------------------------------------------- -Modify these assumptions, and are working on models that incorporate some predictably irrational behavior.

Any institution that significantly affects economic decisions Pretty much anything that affects economic decisions To apply economic theory to reality, you've got to have a sense of ECONOMIC INSTITUTIONS ------------------------------------------------------------------------------- Examples ------------------------------------------------------------------------------- -Laws (Legal) -Common practices -Corporations -Governments -Cultural norms (Cultural)

Actions (or inaction) taken by GOVERNMENT to influence ECONOMIC ACTIONS ------------------------------------------------------------------------------- Examples ------------------------------------------------------------------------------- -Should the government restrict mergers between firms? -Should it run a budget deficit? -Should it do something about the international trade deficit? -Should it decrease taxes?

-It capped the amount of pollutants that firms could emit (COMMAND AND CONTROL APPROACH) -It reduced pollution, but was VERY COSTLY -Economists proposed a "CAP AND TRADE", that achieved the same overall reduction in pollution but at a lower overall cost. An emissions permit market was created --->The CLEAN AIR ACT was amended to include TRADABLE EMISSIONS PERMITS. An active market in emissions permits developed.

•It keeps the analyst's judgments SEPARATE from the analysis Subjective Analysis: "This is the way things should be" Objective Analysis "This is the way the ECONOMY works"

To make the distinction between OBJECTIVE and SUBJECTIVE analysis, economists have divided economics into 3 categories: -------------------------------------------------------------------------------- "PAN" -------------------------------------------------------------------------------- 1. Positive Economics 2. Art of Economics 3. Normative Economics

The study of what is, and how the economy works. It explores the PURE THEORY of economics, and discovers agreed upon EMPIRICAL REGULARITIES (empirical facts) -------------------------------------------------------------------------------- "EXAMPLE" -------------------------------------------------------------------------------- •Large Price fluctuations in financial markets tend to be followed by additional large price fluctuations •This is an example of an EMPIRICAL REGULARITY or EMPIRICAL FACT •Positive Economics asks such questions as: •How does the market for hog bellies work? •How do price restrictions affect market forces?

•The application of the knowledge learned in POSITIVE ECONOMICS to achieve the goals one has determined in NORMATIVE ECONOMICS •Most POLICY DISCUSSIONS fall under the ART OF ECONOMICS. •The ART OF ECONOMICS branch is SPECIFICALLY ABOUT POLICY •It is designed to arrive at PRECEPTS, or guides for policy. -------------------------------------------------------------------------------- "EXAMPLE" -------------------------------------------------------------------------------- •Art of Economics looks at questions such as: •To achieve the goals that society wants to achieve, how would you go about it, given the way the economy works?

•The study of what the goals of the economy should be •It is easy to assume that all of society shares your values, but that assumption is often WRONG -------------------------------------------------------------------------------- "EXAMPLE" -------------------------------------------------------------------------------- •Some economists are worried about global warming •These economists argue that society's normative goal should include a much greater focus on the implications of economic activities for global warming, and the distribution of income, than is currently the case. •Normative Economics asks such questions as: •What should the distribution of income be? •What should tax policy be designed to achieve? •In discussing these goals, economists should carefully consider if they are discussing their OWN GOALS or SOCIETY'S GOALS

•The choice of POLICY options depends on much more than economic theory: •POLITICIANS, not economists, determine economic policy •Must take into account these forces: •Historical •Social •Cultural •Political • The three coordination problems any economy must solve are what to produce, how to produce it, and for whom to produce it. In solving these problems, societies have found that there is a problem of scarcity. • Economics can be divided into microeconomics and macroeconomics. Microeconomics is the study of individual choice and how that choice is influenced by economic forces. Macroeconomics is the study of the economy as a whole. It considers problems such as inflation, unemployment, business cycles, and growth. • Economic reasoning structures all questions in a cost/ benefit framework: If the marginal benefits of doing something exceed the marginal costs, do it. If the 20 Introduction ■ Thinking Like an Economist marginal costs exceed the marginal benefits, don't do it. • Sunk costs are not relevant in the economic decision rule. • The opportunity cost of undertaking an activity is the benefit you might have gained from choosing the next-best alternative. • "There ain't no such thing as a free lunch" (TANSTAAFL) embodies the opportunity cost concept • Economic forces, the forces of scarcity, are always working. Market forces, which ration by changing prices, are not always allowed to work • Economic reality is controlled and directed by three types of forces: economic forces, political forces, and social forces. •Under certain conditions, the market, through its price mechanism, will allocate scarce resources efficiently. •Theorems are propositions that follow from the assumptions of a model; precepts are the guides for policies based on theorems, normative judgments, and empirical observations about how the real world differs from the model. •Economics can be subdivided into positive econom- ics, normative economics, and the art of economics. Positive economics is the study of what is, norma- tive economics is the study of what should be, and the art of economics relates positive to normative economics.