201: Principles of Macroeconomics PDF

***What is Economics?*** **Economics (**Is a social science that studies how people behave)**:** The study of how individuals and societies ***allocate*** their limited resources to satisfy their practically unlimited wants Seeks to answer how individuals and societies make decisions about sc...

***What is Economics?*** **Economics (**Is a social science that studies how people behave)**:** The study of how individuals and societies ***allocate*** their limited resources to satisfy their practically unlimited wants Seeks to answer how individuals and societies make decisions about scarce resources **Scarcity:** Refers to the inherently limited nature of society's resources, given society's unlimited wants and needs Microeconomics: Macroeconomics: ------------------------------------------------------------ -------------------------------------------------------------------------------------------------- The focus is on individuals, businesses, and/or industries The study of the overall aspects and workings of an economy The focus is on the "big picture." ***What are the Five Foundations of Economics?*** ***1. Incentives*** Positive Incentives: Factors that motivate a person to act or exert effort Used to affect how people respond Example: getting paid to do a job Economics can be summarized in one simple phrase: People *respond* to incentives Examples : Patent: a form of intellectual property that gives its owner the legal right to exclude others from making, using, or selling an invention for a limited period of years Copyright: a form of intellectual property that gives its owner the exclusive right to make copies of a creative work Patents and copyrights are incentives to innovate Negative incentives: Incentives that discourage action by providing undesirable consequences or punishments Negative incentive examples: Going to jail for stealing a computer from a store, speeding tickets, higher gasoline prices causing consumers to drive less Direct incentives: "Here is what I want you to do, and here is what I am going to do to get you to do it." Typically easy to recognize Indirect incentives: A secondary change in behavior brought on by the original incentive Typically challenging to recognize Unintended consequence: An unplanned result (usually negative and unwanted) of an incentive Example: welfare programs What is the intended effect of these programs? Alleviate the suffering from poverty. Ensure people have enough food to eat and a place to live What may be an unintended consequence of these programs? People could choose not to work ***2. Trade-offs*** In a world of scarcity, every decision incurs a cost. Doing one thing often means you will not have the time, resources, or energy to do something else. Understanding the trade-offs that exist in life can completely change how you view the world Examples: If you go to EMU full-time, you can't attend another school full time ***3. Opportunity cost*** The highest-valued alternative that must be sacrificed to get something else Every time we make a choice, we experience an opportunity cost. The key to making the best possible decision is to minimize your opportunity cost by selecting the option that gives you the ***most significant benefit*** ***4. Marginal thinking*** Requires decision-makers to evaluate whether the benefit of one more unit of something is greater than the cost of one more unit. Marginal benefit: Additional benefit derived from the extra unit Marginal cost: Additional cost incurred from the extra unit ***Example:*** Suppose you are cleaning your kitchen. Do you clean underneath the refrigerator? Marginal benefit: small additional amount of floor cleaned Marginal cost: requires more time and effort This decision requires a cost-benefit analysis at the margin Clean underneath the refrigerator if the marginal benefit is greater than the marginal cost ***5. Trade creates value*** The ***voluntary*** exchange of goods and services between two or more parties. You don't engage in trade if it makes you worse off! Trade only occurs if both parties feel that they ***gain*** from the trade Trade fosters the exchange of goods and promotes specialization Specialization and the trading of services exist at the business level: Starbucks specializes in making coffee Honda specializes in making cars ***Markets:*** bring buyers and sellers together to exchange goods and services Examples:  ***Circular flow diagram:*** Shows how goods, services, and resources flow through the economy via commerce between households and firms Households are consumers who desire the goods and services produced by firms Firms are businesses that require the resources owned by households to produce goods and services Two components: Resource market Product market ***Comparative advantage*** (C.A.) The situation where an individual, business, or country can produce at a lower opportunity cost than a competitor C.A. Harnesses the power of specialization, which results in people being able to focus on doing the things they are best at and not having to do everything themselves Specialization and the trading of services exist at the international level. Some countries have highly developed workforces capable of managing and solving complex processes, while others have large pools of relatively unskilled labor. However, when goods and jobs are free to move across borders, not everyone benefits equally Example: a U.S. worker employed by a U.S. firm loses her job when her position is outsourced to a worker in India The unemployed worker in the U.S. must find new employment The worker in India now has a new job and is better off The U.S. firm enjoys the advantage of hiring lower-cost labor in India, which can translate into charging lower prices to its U.S. customers ***How Do Economists Study the Economy?*** *The economist's laboratory is the **world around us.*** Economists use models to understand the complex real-world economy. Models simplify reality by making assumptions (Economists cannot always design experiments to test their hypotheses). Economics is a social science that uses the scientific method to develop economic models that are used to explain economic phenomena (Economists often gather historical data or wait for real-world events to take place (i.e., natural experiments) Models are considered reasonable if they make accurate predictions ( To create economic models, economists make many assumptions to simplify reality ) Economic models tend to be based on mathematical equations and graphs (Economists study the overall economy as well as the individual decisions made by firms and consumers) Example of an economic model: supply and demand (Economic models help economists understand the key relationships that drive financial decisions) ***Positive and Normative Analysis*** Positive (+) - Factual Normative (-) - Opinionated ***Economic Models*** Economists use models to understand the complex real-world economy Models simplify reality by making assumptions Models are considered reasonable if they make accurate predictions Economic models tend to be based on mathematical equations and graphs Example of an economic model: supply and demand When building a model, economists must decide What variables to include/exclude Excluding the wrong variables or making faulty assumptions can lead to problems *** Example: 2008 financial crisis*** It is necessary to examine often and re-evaluate the assumptions of economic models ***Ceteris paribus: A Latin phrase that means "other things being equal" or "all else equal" and is used to build economic models*** ***Endogenous Vs. Exogenous Factors*** +-----------------------------------+-----------------------------------+ | Endogenous factors: | Exogenous factors: | +===================================+===================================+ | The variables that are inside | The variables that are outside | | (i.e., determined by) a model | of (i.e., not determined by) a | | | model | | Example: price and quantity in | | | a supply and demand model | Example: consumers' income in a | | | supply and demand model | +-----------------------------------+-----------------------------------+ ***Conclusion*** Economists ask and answer big questions about life, which makes the study of economics so fascinating Once you have learned the fundamentals of economics, you can use them to analyze almost any problem