Rational People Make Decisions At The Margin – Ten Principles of Economics Essay Example

economic “pie. ” TEN PRINCIPLES OF ECONOMICS 5 1 6/7/2010 HOW PEOPLE MAKE DECISIONS

Principle #2:

• The Cost of Something Is What You Give Up to Get It Making decisions requires comparing the costs and benefits of alternative choices. The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making. HOW PEOPLE MAKE DECISIONS Principle #2: The Cost of Something Is What You Give Up to Get It Examples: The opportunity cost of… going to college for a year is not just the tuition, books, and fees, but also the foregone wages. …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater. TEN PRINCIPLES OF ECONOMICS 6 TEN PRINCIPLES OF ECONOMICS 7 HOW PEOPLE MAKE DECISIONS

Principle #3:

• Rational People Think at the Margin Rational people systematically and purposefully do the best they can to achieve their objectives. make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an existing plan. HOW PEOPLE MAKE DECISIONS

Principle #3:

• Rational People Think at the Margin Examples: When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue. 8 TEN PRINCIPLES OF ECONOMICS TEN PRINCIPLES OF ECONOMICS 9 HOW PEOPLE MAKE DECISIONS

Principle #4:

• People Respond to Incentives Incentive: something that induces a person to act, i. e. the prospect
  

of a reward or punishment.

Rational people respond to incentives. Examples: When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs. When cigarette taxes increase, teen smoking falls. 10 ACTIVE LEARNING 1 Applying the principles You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is. ” In each of the following scenarios, should you have the transmission repaired? Explain. A. Blue book value is $6500 if transmission works, $5700 if it doesn’t B.

Blue book value is $6000 if transmission works, $5500 if it doesn’t TEN PRINCIPLES OF ECONOMICS 11 2 6/7/2010 ACTIVE LEARNING 1 ACTIVE LEARNING 1 Answers Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesn’t Answers Observations: The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit of the marginal repair (the transmission). The change in incentives from scenario A to scenario B caused your decision to change. Benefit of fixing the transmission = $800 ($6500 – 5700). It’s worthwhile to have the transmission fixed.

B. Blue book value is $6000 if transmission works, $5500 if it doesn’t Benefit of fixing the transmission is only $500. Paying $600 to fix transmission is not worthwhile. 12 13 The principles of HOW PEOPLE INTERACT HOW PEOPLE INTERACT

Principle #5:

• Trade Can Make Everyone Better Off Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. Countries also benefit from trade & specialization: Get a better
  

price abroad for goods they produce Buy other goods more cheaply from abroad than could be produced at home TEN PRINCIPLES OF ECONOMICS 5 HOW PEOPLE INTERACT

Principle #6:

• Markets Are Usually A Good Way to Organize Economic Activity Market: a group of buyers and sellers (need not be in a single location) “Organize economic activity” means determining what goods to produce how to produce them how much of each to produce who gets them TEN PRINCIPLES OF ECONOMICS 16 HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets.

Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households and firms acts as if “led by an invisible hand” to promote general economic well-being. TEN PRINCIPLES OF ECONOMICS 17 3 6/7/2010 HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity The invisible hand works through the price system: The interaction of buyers and sellers determines prices. Each price reflects the good’s value to buyers and the cost of producing the good. Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being.

TEN PRINCIPLES OF ECONOMICS 18 HOW PEOPLE INTERACT

Principle #7:

• Governments Can Sometimes Improve Market Outcomes Important role for govt: enforce property rights (with police, courts) People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. TEN PRINCIPLES OF ECONOMICS 19 HOW PEOPLE INTERACT

Principle #7:

• Governments Can Sometimes Improve Market Outcomes Market failure: when the market fails
  

to allocate society’s resources efficiently Causes: Externalities, when the production or consumption of a good affects bystanders (e. g. ollution) Market power, a single buyer or seller has substantial influence on market price (e. g. monopoly) HOW PEOPLE INTERACT

Principle #7:

• Governments Can Sometimes Improve Market Outcomes Govt may alter market outcome to promote equity If the market’s distribution of economic well-being is not desirable, tax or welfare policies can change how the economic “pie” is divided. In such cases, public policy may promote efficiency. TEN PRINCIPLES OF ECONOMICS 20 TEN PRINCIPLES OF ECONOMICS 21 ACTIVE LEARNING 2 Discussion Questions In each of the following situations, what is the government’s role?

Does the government’s intervention improve the outcome? a. Public schools for K-12 b. Workplace safety regulations c. Public highways d. Patent laws, which allow drug companies to charge high prices for life-saving drugs The principles of HOW THE ECONOMY AS A WHOLE WORKS 22 4 6/7/2010 HOW THE ECONOMY AS A WHOLE WORKS

Principle #8:

• A country’s standard of living depends on its ability to produce goods & services. Huge variation in living standards across countries and over time: Average income in rich countries is more than ten times average income in poor countries. The U. S. tandard of living today is about eight times larger than 100 years ago. HOW THE ECONOMY AS A WHOLE WORKS Principle #8: A country’s standard of living depends on its ability to produce goods & services. The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor. Productivity depends on the equipment, skills, and technology available to workers. Other factors (e. g.
  

, labor unions, competition from abroad) have far less impact on living standards. TEN PRINCIPLES OF ECONOMICS 24 TEN PRINCIPLES OF ECONOMICS 25

HOW THE ECONOMY AS A WHOLE WORKS

Principle #9:

• Prices rise when the government prints too much money. Inflation: increases in the general level of prices. In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall. The faster the govt creates money, the greater the inflation rate. HOW THE ECONOMY AS A WHOLE WORKS

Principle #10:

• Society faces a short-run tradeoff between inflation and unemployment In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions.

Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.

TEN PRINCIPLES OF ECONOMICS 26 TEN PRINCIPLES OF ECONOMICS 27 FYI: How to Read Your Textbook

• 1. Read before class. You’ll get more out of class.
• 2. Summarize, don’t highlight. Highlighting is a passive activity that won’t improve your comprehension or retention. Instead, summarize each section in your own words. Then, compare your summary to the one at the end of the chapter. FYI: How to Read Your Textbook
• 3. Test yourself. Try the “Quick Quiz” that follows each section before moving on to the next section. Write your answers down, compare them to the answers in the back of the book. If your answers are incorrect, review the section before moving on.
• 4. Practice, practice, practice. Work through the end-of-chapter review questions and problems. They are often good practice for the exams. And the more you use your new knowledge, the more solid
  

it will become. 28 TEN PRINCIPLES OF ECONOMICS TEN PRINCIPLES OF ECONOMICS 29 5 6/7/2010 FYI: How to Read Your Textbook

TEN PRINCIPLES OF ECONOMICS 31 CHAPTER SUMMARY CHAPTER SUMMARY

The principles of decision making are: People face tradeoffs. The cost of any action is measured in terms of foregone opportunities. Rational people make decisions by comparing marginal costs and marginal benefits.

People respond to incentives. 32 The principles of interactions among people are: Trade can be mutually beneficial. Markets are usually a good way of coordinating trade. Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable.

CHAPTER SUMMARY

The principles of the economy as a whole are: Productivity is the ultimate

source of living standards. Money growth is the ultimate source of inflation. Society faces a short-run tradeoff between inflation and unemployment. 34 6