ECON 103 - Chapter 2 Principles of Microeconomics PDF

Principles of Microeconomics ECON 103 – 2024/25 Dr. Hussain Muhammad 1  CH 2: Ten Principles of Economics Ten Principles of Economics How People Make Decisions 1: People Face Trade-offs 2: The Cost of Something Is What Yo...

Principles of Microeconomics ECON 103 – 2024/25 Dr. Hussain Muhammad 1  CH 2: Ten Principles of Economics Ten Principles of Economics How People Make Decisions 1: People Face Trade-offs 2: The Cost of Something Is What You Give Up to Get It 3: Rational People Think at the Margin 4: People Respond to Incentives How People Interact 5: Trade Can Make Everyone Better Off 6: Markets Are Usually a Good Way to Organize Economic Activity 7: Governments Can Sometimes Improve Market Outcomes How the Economy as a Whole Works 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services 9: Prices Rise When the Government Prints Too Much Money 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment 2  CH 2: Ten Principles of Economics Principle 1: People Face Trade-offs There is no such thing as a free lunch. To get one thing we like, we usually have to give up another thing we like. Making decisions requires trading off one goal against another. Examples: Personal Decision: Choosing to study instead of working part-time. Government Policy: Allocating the budget to healthcare means less funding for education. Business: A company deciding between investing in new technology or expanding its workforce. 3  CH 2: Ten Principles of Economics Principle 2: The Cost of Something Is - What You Give Up to Get It Because people face trade-offs, making decisions requires individuals to consider the benefits and costs of some action. Cost and benefits analysis involves comparing the costs of an action or decision to the potential benefits that it could bring. Opportunity cost is the cost of giving up one opportunity in order to take another one. The ‘next best alternative’ that must be given up comes with a cost. When making any decision, decision makers should be aware of the opportunity costs that accompany each possible action. 4  CH 2: Ten Principles of Economics Principle 2: The Cost of Something Is - What You Give Up to Get It Example 1: Choosing to study for an exam instead of hanging out with friends comes with a cost. Studying for exams instead of handing out with friends will likely bring higher grades in an exam. The opportunity cost in this example is the time spent with friends. Example 2: You may be faced with making the choice: get a job straight out of university or take a gap year. If you choose to take the job, you’re giving up an amazing and educational travel experience. If you choose to take a gap year, you’re giving up a lot of money. Either way, you’re giving up one thing to achieve the other. 5  CH 2: Ten Principles of Economics Principle 3: Rational People Think at the Margin Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities. Marginal changes are small, incremental adjustments to an existing plan of action. These are not major changes but rather fine-tuning to optimize outcomes. Rational people make decisions by comparing the additional (marginal) benefits of an action to its additional (marginal) costs. If the marginal benefit exceeds the marginal cost, the action is considered rational and should be taken. 6  CH 2: Ten Principles of Economics Principle 3: Rational People Think at the Margin Marginal Benefit: The extra benefit that a producer gets from producing one more unit of a good. Marginal cost: Marginal cost is how much extra it costs to produce additional units of goods or services. Example: Consider a student deciding whether to study an extra hour for a test. The marginal benefit might be a higher score, potentially leading to a better grade. However, the marginal cost could be less sleep, increased stress, or missing out on social activities. The decision depends on whether the perceived benefit outweighs the cost. A firm must decide whether to produce one more unit of a product. The marginal cost includes the additional expenses for materials, labor, and energy required to produce that unit. The marginal benefit is the additional revenue generated from selling it. If the marginal revenue exceeds the marginal cost, it’s rational for the firm to produce the additional unit. 7  CH 2: Ten Principles of Economics Principle 4: People Respond to Incentives Incentives: Factors that motivate individuals to act in certain ways. Types of Incentives Positive Incentives: Rewards for certain behaviors (e.g., tax breaks). Negative Incentives: Punishments or penalties for certain behaviors (e.g., fines). Economic incentives are financial motivations for people to take certain actions. Because rational people make decisions by comparing costs and benefits, they respond to incentives. Example: When the price of apples rises, people decide to eat fewer apples. At the same time, apple orchards hire more workers and harvest more apples. 8  CH 2: Ten Principles of Economics Principle 5: Trade Can Make Everyone Better Off Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Trade between two countries can benefit each country. Example: Consider two countries: one with rich in oil and another with advanced technology for manufacturing cars. The oil-producing country can specialize in oil production and trade it for cars produced by the other country. Both benefit from trade by focusing on what they produce most efficiently and exchanging their surplus for goods they need. 9  CH 2: Ten Principles of Economics Principle 6: Markets Are Usually a Good Way to Organize Economic Activity Market Economy: A market economy refers to a form of economic system where firms and households drive the economy with minimal or no government intervention. Centralized Economy: A centrally planned economy is an economic system where a government body makes economic decisions regarding the production and distribution of goods. Most countries that once had centrally planned economies have abandoned the system and are instead developing market economies. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions. 10  CH 2: Ten Principles of Economics Principle 7: Governments Can Sometimes Improve Market Outcomes The government enforces the rules and maintains the institutions that are key to a market economy. Most important, market economies need institutions to enforce property rights so individuals can own and control scarce resources. We all rely on government-provided police and courts to enforce our rights over the things we produce. Examples: A farmer won’t grow food if he expects his crop to be stolen; a restaurant won’t serve meals unless it is assured that customers will pay before they leave; and an entertainment company won’t produce DVDs if too many potential customers avoid paying by making illegal copies. 11  CH 2: Ten Principles of Economics Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services Differences in living standards from one country to another are quite large. The explanation for these differences in living standards lies in differences in productivity. Productivity refers to how much output (the quantity of goods and services) can be produced with a given set of inputs (unit of labor). In nations where workers can produce a large quantity of goods and services per unit of time, most people enjoy a high standard of living; in nations where workers are less productive, most people endure a more insufficient existence. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology. 12  CH 2: Ten Principles of Economics Principle 9: Prices Rise When the Government Prints Too Much Money Inflation is an increase in the overall level of prices in the economy. In the simplest possible terms, inflation is what happens when prices go up and therefore the purchasing power of money goes down. Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of economic policymakers around the world. What causes inflation? In almost all cases of large or persistent inflation, the reason is growth in the quantity of money. When a government creates large quantities of the nation’s money, the value of the money falls. 13  CH 2: Ten Principles of Economics Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment Most economists describe the short-run effects of monetary injections as follows: Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services. Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. More hiring means lower unemployment. 14  CH 2: Ten Principles of Economics Summary The fundamental lessons about individual decision making are that people face trade-offs among alternative goals, that the cost of any action is measured in terms of forgone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behavior in response to the incentives they face. The fundamental lessons about interactions among people are that trade and interdependence can be mutually beneficial, that markets are usually a good way of coordinating economic activity among people, and that the government can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality. The fundamental lessons about the economy as a whole are that productivity is the ultimate source of living standards, that growth in the quantity of money is the ultimate source of inflation, and that society faces a short-run trade-off between inflation and unemployment. 15