Ten Principles of Economics PDF

CHAPTER Ten Principles of Economics Goal s Learn that economics is about the allocation of scarce resources In this chapter you will Examine some of the trade-otIS that people face Learn the meaning of opportunity cost See...

CHAPTER Ten Principles of Economics Goal s Learn that economics is about the allocation of scarce resources In this chapter you will Examine some of the trade-otIS that people face Learn the meaning of opportunity cost See how to use marginal reasoning when making decisions Discuss how incentives affect people's behavior Consider why trade among people or nations can be good for everyone Discuss why markets are a good, but not perfect, way to ,allocate resources Learn what determines some trends in the overall economy Outcomes Define scarcity After accomplishing Explain the classic trade-off between "guns and butter" these goals, you Add up your particular opportunity cost of attending college should be able to Compare the marginal costs and marginal benefits of continuing to attend school indefinitely Consider how a quadrupling ofyour tuition payments would affect your decision to educate yourself EX"plai~ why specialization and trade improve people's choices Give an example of an externality Explain the source oflarge and persistent inflation 2 PART I INTRODUCTION Chapter Overview Purpose Chapter 1 is the first chapter in a three-chapter section that serves as the introduction to the text. Chapter 1 introduces ten fundamental principles on which the study of economics is based. In a broad sense, the rest of the text is an elaboration on these ten principles. Chapter 2 will develop how economists approach problems, while Chapter 3 will explain how individuals and countries gain from trade. The purpose of Chapter 1 is to layout ten economic principles that will serve as building blocks for the rest of the text. The ten principles can be grouped into three categories: how people make decisions, how people interact, and how the economy works as a whole. Throughout the text, references will be made repeatedly to these ten principles. Chapter Review Introduction Households and society face decisions about how to allocate scarce resources. Resources are scarce in that we have fewer resources than we wish. Economics is the study of how society manages its scarce resources. Economists study how people make decisions about buying and selling, and and investing. We study how people interact vvith one another in markets where prices are determined and quantities are exchanged. We also study the economy as a whole when we concern ourselves with total income, unemployment, and inflation. This chapter addresses ten principles of economics. The text will refer to these principles throughout. The ten principles are grouped into three categories: how people make decisions, how people interact, and how the economy works as a whole. How People Make Decisions l1li face trade-offs Economists often say, "There ain't no such thing as a free lunch."This means that there are always trade-ofls--to get more of something we like, we have to give up something else that we like. For example, if you spend money on dinner and a movie, you won't be able to spend it on new clothes. Socially, we face trade-ofts as a group. For example, there is the classic trade-off between "guns and butter."That is, if society spends more on national defense (guns), then it will have less to spend on social programs (butter). There is also a social trade-off between efficiency (getting the most from our scarce resources) and equality (benefits being distributed uniformly across society). Policies such as taxes and welfare make incomes more equal, bur these policies reduce returns to hard work, and thus, the economy doesn't produce as much. As a result, when the government tries to cut the pie into more equal pieces, the pie gets smaller. III The cos~ of is what you up to get it The opportunity cost of an item is what you give up to get that item. It is the true cost of the item. The opportunity cost of going to college obviously includes your tuition payment. It also includes the value of your time that you could have spent working, valued at your potential earnings. It would exclude your room and board payment because you have to eat and sleep whether you are in school or not. III Rational think at the margin Rational people systematically do the best they can to achieve their objectives. Marginal changes are inoremental changes to an existing plan. Rational decision makers only proceed with an action if the marginal benefit exceeds the marginal cost. For example, you should only attend school for another year if the benefits from that year of schooling exceed the cost of attending that year. A farmer should produce another bushel of corn only if the benefit (price received) exceeds the cost of producing it.  CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 3 II Pe-ople respond to incentives An incentive is something that induces a person to act. Because rational people weigh marginal costs and marginal benefits of activjties, they will respond when these costs or benefits change. For example, when the price of automobiles rises, buyers have an incentive to buy fewer cars while autom~)bile producers have an incentive to hire more workers and produce more autos. Public policy can alter the costs or benefits of activities. For example, a luxury tax on expensive boats raises the price and discourages purchases. Some policies have unintended consequences because they alter behavior in a manner that was not predicted. How People Interact III Trade can make everyone better off Trade is not a contest in which one wins and one loses. Trade can.make each trader better off. Trade allows each trader to specialize in what he or she does best, whether it be farming, building, or manufacturing, and trade their output for the output of other efficient producers. This is as true for countries as it is for individuals. III Markets are usually a good way to organize economic activity In a market economy, the decisions about what goods and services to produce, how much to produce, and who gets to consume them are made by millions of firms and households. Firms and households, guided by self-interest, interact in the marketplace where prices and quantities are determined. Although this may appear to be chaos, Adam Smith made the famous observation in the ~vealth o.f Nations in 1776 that self-interested households and firrns interact in markets and generate desirable social outcomes as if guided by an "invisible hand."These optimal social outcomes were not their original intent. The prices generated by their, competitive activity signal the value of costs and benefits to producers and consumers, whose activities usually maximize the well-being of society: Alternatively, the prices dictated by central planners contain no information on costs and benefits, and therefore, th~se prices fail to guide economic activity efficiently. Prices also fail to guide economic activity efficiently when goveruments distort prices with taxes or restrict price movements with price controls. II Governments can sometimes itnprove market outcomes Government must first protect property rights in order for markets to work. In addition, government can sometimes intervene in the market to improve efficiency or equality. When markets fail to allocate resources efflCiently, there has been market failure, There are many different sources of market failure. An externality is when the actions of one person affect the well-being of a bystander. Pollution is a standard example. Market power is when a single person or group can influence the price. In these cases, the government may be able to intervene and improve economic efficiency. The government may also intervene to improve equality with income taxes and welfare. Sometimes well-intentioned policy intervention has unintended consequences. How the Economy as a Whole Works III A country's standard of living depends on its ability to produce goods and services There is great variation in average incomes across countries at a point in time and within the same country over time. These differences in incomes and standards of living are largely attributable to differences in productivity. Productivity is the amount of goods and services produced from each unit oflabor input. As a result, public policy intend~d to improve standards of living should improve education, generate more and better tools, and improve access to current technology. II Prices rise when the government prints too much money Inflation is an increase in the overall level of prices in the economy. High inflation is costly to the economy. Large and persistent inflation is caused by rapid growth in the quantity of 4 PART I INTRODUCTION money. Policymakers wishing to keep inilation low should maintain slow growth in the quantity of money. III Society faces a short-run trade-oft" between inflation and unemployntent In the short run, an increase in the quantity of money stimulates spending, which raises both prices and production. The increase in production requires more hiring, which reduces unemployment. Thus, in the short run, an increase in inflation tends to reduce unemployment, causing a trade-off between inflation and unemployment. The trade-off is temporary but can last for a year or two. Understanding this trade-off is important for understanding the fluctuations in economic activity known as the business cycle. In the short run, pohcymakers may be able to affect the mix of inflation and unemployment by changing government spending, taxes, and the quantity of money. J.I:'.lIJ.LU.l Hints. 1. Place yourself in the story. Throughout the text, most economic situations will be composed of economic actors-buyers and sellers, borrowers and lenders, firms and workers, and so on.When you are asked to address how any economic actor would respond to economic incentives, place yourself in the story as the buyer or the seller, the borrower or the lender, the producer or the consumer. Don't think of yourself always as the buyer (a natural tendency) or always as the seller.You will tlnd that your role-playing will usually produce the right response once you learn to think like an economist-which is the topic of the next chapter. 2. Trade is not a zero-sum game. Some people see an exchange in terms of winners and losers. Their reaction to trade is that, after the sale, if the seller is happy, the buyer must be sad because the seller must have taken something from the buyer. That is, they view trade as a zero-sum game where what one gains the other must have lost. They fail to see that both parties to a voluntary transaction gain because each party is allowed to specialize in what it can produce most efficiently and then trade for items that are produced more efficiently by others. Nobody loses, because trade is voluntary. Therefore, a government policy that limits trade reduces the potential gains from trade. 3. An externality can be positive. Because the classic example of an externality is pollution, it is easy to think of an externality as a cost that lands on a bystander. However, an externality can be positive in that it can be.a benefit that lands on a bystander. For example, education is often cited as a product that emits a positive externality because when your neighbor educates herself, she is likely to be more reasonable, responsible, productive, and politically astute. In short, she is a better neighbor. Positive externalities, just as much as negative externalities, may be a reason for the government to intervene to promote efficiency.  CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5 and Detlnitions Choose a definition for each key term. Terms Definitions ___ Scarcity '1. The property of distributing economic prosperity uniformly among society's members Economics 2. A situation in which the market fails to allocate ___ Efficiency resources efficiently _ _ Equality 3. Limited resources and unlimited wants 4. The amount of goods and services produced from Rational each unit of labor input __ Opportun~ty cost 5. The case in which there is only one seller in the _ _ Marginal changes market 6: The principle that self-interested market Incentive participants may unknowingly maximize the ___ Market economy welfare of society as a whole Property rights 7. The property of society getting the most from its scarce resources "lnvisible hand" 8. An economic system where interaction of Market failure households and fIrms in markets determines the allocation of resources Externality 9. Fluctuations in economic activity ___ Market power 10. When one person's actions have an impact on a _ _ Monopoly bystander Productivity 11. An increase in the overall level of prices 12. Incremental adjustments to an existing plan Inflation 13. Study of how society manages its scarce resources ___ Business cycle 14. Whatever is given up to get something else 15. The ability of an individual or group to substantially influence market prices 16. Something that induces a person to act 17. The ability of an individual to own and exercise control over scarce resources 18. Systematically and purposefully doing the best you can to achieve your objectives 6 PART I INTRODUCTION Problems and Short-Answer Questions ---.. ProblelTIS 1. People respond to incentives. Governments can alter ince!1tives and, hence, be­ havior with public policy. However, sometimes public policy generates unintended consequences by producing results that were not anticipated. For each of the following public policies, determine which result was likely the intended result and which was the unintended consequence. a. The government raises the minimum wage to $10 per hour. Some workers find jobs at the higher wage making these workers better off. Some workers fmd no job at all because few firms want to hire low-productivity workers at this high wage. b. The government places rent controls on apartments restricting rent to $300 per month. Few landlords are willing to produce an apartment at this price causing more homelessness. Some low-income renters are able to rent an apartment more cheaply. c. The government raises the tax on gasoline by $2 per gallon. The deficit is reduced, and people economize on their use of gasoline. There is a boom in bicycle sales. d. The government declares marijuana and cocaine illegal. The price of illegal drugs increases, creating more gangs and gang warfare. Due to the high price of illegal drugs, fewer street drugs are consumed. e. The government prohibits the killing of wolves. The wolf population increases. Sheep and cattle herds suffer losses... __.__. - - _.. _.. ­ f The government bans imports of sugar from South America. South American sugar beet growers can't repay their loans to U.S. banks and rum to more profitable crops such as coca leaves and marijuana. U.S. sugar beet growers avoid a financial crisis. ~~.  CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7 2. Opportunity cost is what you give up to get an item. Because there is no such thing as a free lunch, what would likely be given up to obtain each of the items listed below? a. Susan can work full time or go to college. She chooses college. b. Susan can work full time or go to college. She chooses work. c. Farmer Jones has 100 acres ofland. He can plant corn, which yields 100 bushels per.acre, or he can pla!):t beans, which yield 40 bushels per acre. He chooses to plant corn. -_. __.._---_. d. Farmer Jones has 100 acres ofland. He can plant corn, which yields 100 bushels per acre, or he can plant beans, which yield 40 bushels per acre. He chooses to plant beans. _.__. _ - - - - - - - _.__. _ - - - - - - - - - - - - - - - - - ­ e. In a and b above and c and d above, which is the opportunity cost of which-­ college for work or work for college? corn for beans or beans·for corn? Short-Answer Questions 1. Is air scarce? Is clean air scarce?... _. __._--_......_ - - - - ­ 2. What is the opportunity cost of sa'ling some of your paycheck? 3. Why is there a trade-off between equality and efficiency? 4. Water is necessary for life. Diamonds are not. Is the marginal benefit of an additional glass of water greater or lesser than an additional one-carat diamond? Why?.. __ __. _ - - ­. 8 PART I INTRODUCTION 5. YQur car needs to be repaired. You have already paid $500 to have the transmission fixed, but it still doesn't work properly. You can sell your car "as is" for $2,000. If your car were fixed, you could sell'it for $2,500.Your car can be fixed with a guarantee for another $300, Should you repair your car? Why? ---~ -. -..- -. -..-. -..- -.... "--'--'-"~-'-.-"... " - -. ­ 6. Why do you think air bags have reduced deaths from auto crashes less than we had hoped? 7. Suppose one country is better at producing agricultural products (because they have land that is more fertile), while another country is better at producing manufactured goods (because they lJave a better educational system and more engineers). If each country produced their specialty and traded, would there be more or less total output than if each country produced all of their agricultural and manufacturing needs? Why? - - - - - - - _.._----_.._ - - - - _. __.__..__..­ 8. In the ~Vealth if Nations, Adam Smith said, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."What do you think he meant? " 9, If we save more and use it to build more physical capital, productivity will rise and we will have rising standards ofliving in the future. What is the opportunity cost of[uture growth? to. If the government printed twice as much money, what do you think would happen to prices and output if the economy were already producing at maximum capacity? -~,  CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9 11. A goal for a society is to distribute resources more equally and fairly. How might you distribute resources if everyone were equally talented and worked equally hard? What if people had different talents and some people worked hard, while others did not? 12. Who is more self-interested, the buyer or the seller? Self-Test True/False Questions 1. When the government redistributes income with taxes and welfare, the economy becomes more efficient. 2. When economists say, "There ain't no such thing as a free lunch;' they mean that aU economic decisions involve trade-offs. 3. Adam Smith's "invisible hand" concept describes how corporate business reaches into the pockets of consumers like an ".invisible hand." 4. Rational people act only when the marginal benefit of the action exceeds the marginal cost. 5. The United States will benefit economically if we eliminate trade with Asian countries because we will be forced to produce more of our own cars and clothes. 6. When a jet flies overhead, the noise it generates is an externality. 7. A tax on liquor raises the price of liquor and provides an incentive for consumers to drink more. 8. An unintended consequence of public support for higher education is that low tuition provides an incentive for many people to attend state universities even if they have no desire to learn anything. 9. Sue is better at cleaning, and Bob is better at cooking. It will take fewer hours to eat and clean if Bob specializes in cooking and Sue specializes in cleaning than if they share the household duties evenly. 10. High and persistent inflation is caused by excessive growth in the quantity of money in the economy. 11. In the short run, a reduction in inflation tends to cause a reduction in unemployment. 10 PART I INTRODUCTION 12. An auto manufacturer should continue to produce additional autos as long as the firm is profitable, even if the cost of the additional units exceeds the ~ price received. 13. An individual farmer is likely to have market power in the market for wheat. 14. Tb a student, the opportunity cost of going to a basketball game would include the price of the ticket and the value of the time that could have been spent studying. 15. Workers in the United States have a relatively high standard ofliving because the United States has a relatively high minimum wage. Multiple-Choice 1. Which of the following involve a trade-off? a. buying a new car b. going to college c. watching a football game on Saturday afternoon d. taking a nap e. All of the above involve trade-offs. '2. Trade-olfs are required because wants are unlimited and resources are a. efficient. b. economicaL c. scarce. d. unlimited. e. marginal. 3. Economics is the study of how a. to fully satisfy our unlimited wants. b. society manages its scarce resources. c. to reduce our wants until we are satisfied. d. to avoid having to make trade~offs. e. society manages its unlimited resources. 4. A rational person does not act unless a. the action makes money for the person. b. the action is ethical. c. the action produces marginal costs that exceed marginal benefits. d. the action produces marginal benefits that exceed marginal costs. e. None of the above is true. 5. Raising taxes and increasing welfare payments a. proves that there is such a thing as a free lunch. b. reduces market power. c. improves efficiency at the expense of equality. d. improves equality at the expense of efIiciency. e. does none of the above.  CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11 6. Suppose you fmd $20. If you choose to use the $20 to go to the football game, your opportunity cost of going to the game is a.. nothing, because you found the money. b. $20 (because you could have used the $20 to buy other things). c. $20 (because you could have used the $20 to buy other things) plus the value of your time spent at the game. d. $20 (because you could have used the $20 to buy other things) plus the value ~f your time spent at the game, plus the Cost of the dinner you purchased at the. game. e. none of the above. 7. Foreign trade a. allows a country to have a greater variety of products at a lower cost than if it tried to produce everything at home. b. allows a country to avoid trade-offs. c. makes the members of a country more equal. d. increase'S the scarcity of resources. e. is none of the above. 8. Because people respond to incentives, we would expect that if the average salary of accountants increases by 50 percent while the average salary of teachers increases by 20 percent, a. students will shift majors from education to accounting. b. students will shift majors from accounting to education. c. fewer students will attend college. d. None of the above is true. 9. Which of the following activities is most likely to produce an externality? a. A student sits at home and watches television. b. A student has a party in her dorm room. e. A student reads a novel for pleasure. d. A student eats a hamburger in the student union. 10. Which of the following products would be least capable of producing an externality? a. cigarettes b. stereo equipment c. inoculations against disease d. education e. food 11. Which of the following situations describes the greatest market power? a. a farmer's impact on the price of corn b. Volvo's impact on the price of autos e. Microsoft's impact on the price of desktop operating systems d. a student's impact on college tuition 12. Which of the following statements is true about a market economy? a. Market participants act as if guided by an "invisible hand" to produce outcomes that promote general economic well-being. b. Taxes help prices communicate costs and benefits to producers and consumers. c. With a large enough computer~ central planners could guide production more efficiently than markets. d. The strength of a market system is that it tends to distribute resources evenly across consumers. 12 PART I INTRODUCTION 13. Workers in the United States enjoy a high standard of living because.~, a. unions in the United States keep the \vage high. b. we have protected our industry from foreign competition. c. the United States has a high minimum wage. d. workers in the United States are highly productive. e. None of the above is true. 14. High and persistent inflation is caused by a. unions increasing wages too much. b. OPEC raising the price of oil too much. c. governments increasing the quantity of money too much. d. regulations raising the cost of production too much. 15. In the short run, a. an increase in inflation temporarily increases unemployment. b. a decrease in inflation temporarily increases unemployment. c. inflation and unemployment are unrelated. d. the business cycle has been eliminated. e. None of the above is true. 16. An increase in the price of beefprovides a. information that tell~ consumers to buy more beef. b. information that tells consumers to buy less pork. c. information that tells producers to produce more beef. d. no information because prices in a market system are managed by planning boards.. 17. You have spent $1,000 building a hot-dog stand based on estimates of sales of$2,000.~· The hot-dog stand is nearly completed, but now you estimate total sales to be only $800.You can complete the hot-dog stand for another $300. Should you complete the hot-dog stand? (Assume that the hot dogs cost you nothing.) a. Yes. b. No. c. There is not enough information to answer this question. 18. Referring to question 17, your decision rule should be to complete the hot-dog stand as long as the cost to complete the stand is less than a. $100. b. $300. c. $500. d. $800. e. none of the above. 19. Which of the following is not part of the opportunity cost of going on vacation? a. the money you could have made if you had stayed home and worked b. the money you spent on food c. the money you spent on airline tickets d. the money you spent on a Broadway show 20. Productivity can be increased by a. raising minimum wages. b. raising union wages. c. improving the education of workers. d. restricting trade with foreign countries.  CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 13 Advanced Critical Thinking Suppose your university decides to lower the cost of parking on campus by reducing the price ofa parking permit from $200 per semester to $5 per semester. 1. What do you think would happen to the number of stud~nts desiring to park their cars on campus? --~~.. ------------------------------­ ---- "'--~~--'~-' - - _..._ - - - - _..._ - - - - - - ­ 2. What do you think would happen to the amount of time it would take to fmd a parking place? 3. Thinking in terms of opportunity cost, would the lower price of a parking permit necessarily lower the true cost of parking? ----~.. _ - - -..... _ - - - - - - ~--... --~---... ~- - - --.-.........­ 4. Would the opportunity cost of parking be the same for students with no outside employment and students with jobs earning $15 per hour? -------...-~..- - -.. - -..- - -..-...- - - - - - - - ­ 14 PART I INTRODUCTION Solutions Terms and Definitions without giving up something to get it (pollution ;L Scarcity equipment on cars, etc.). 13 Economics 2. The items you could have enjoyed had you spent that portion of your paycheck (current L Efficiency consumption). 1.. Equality 3. Taxes and welfare make us more equal· but reduce Rational incentives for hard work, lowering total output. 1±..Opportunity cost 4. The marginal benefit of another glass of water is 12 Marginal changes generally lower because we have so much water Incentive that one more glass is of little value. The opposite 8... Market economy is true for diamonds. 17 Property rights 5. Yes, because the marginal benefit of fixing the car "Invisible hand" is $2,500 $2,000 $500, and the marginal cost is 2- Market failu~e $300. The original repair payment is not relevant. 1Q Externality 6. The cost of an.accident was lowered. This changed incentives, so people drive faster and have more 15. Market power, accidents. 5... Monopoly 7. There would be more total output if the two 4 Productivity countries specialize and trade because each is 11 Inflation doing what it does most efficiently..2.- Business cycle 8. The butcher, brewer, and baker produce the best food possible, not out of kindness, but because it Practice Probletns is in their best interest to do so. Self-interest can 1. a. Intended: Raise the wage of low-productiv­ maximize general economic well-being. ity workers. Unintended: Some workers are 9. We must give up consumption today. unemployed at the higher wage. 10. Spending :would double, but because the quantity b. Intended: Low-income renters get a cheap of output would remain the same, prices would apartment. Unintended: Some people find no double. apartment at all causing more homelessness. 11. Fairness niight require that everyone get an equal c. Intended: Reduce the deficit and use less gasoline. share because they were equally talented and Unintended: Bicycle sales increase. worked equally hard. Fairness might require that d. Intended: Fewer street drugs are consumed. people not get an egual share because they were Unintended: More gangs and gang warfare. not equally talented and did not work equally e. Intended: Increase the wolf population. hard. Unintended: Damage to sheep and cattle herds. 12. They are equally self-interested. The seller will sell £. Intended: Improve the financial conditiotl of U.S. to the highest bidder, and the buyer will buy from sugar beet growers. Unintended: Cause South. the lowest offer. American growers to grow marijuana and coca leaves. True/False Questions 2. a. Susan gives up income from work (and must pay 1. F; the economy becomes less efficient because it tuition). decreases the incentive to work hard. b. Susan gives up a college degree and the increase 2. T in income through life that it would have brought 3. F; the "invisible hand" refers to how markets guide her (but doesn't have to pay tuition). self-interested people to create desirable social c. Farmer Jones gives up 4,000 bushels of beans. outcomes. d. Farmer Jones gives up 10,000 bushels of corn. 4. T e. Each is the opportunity cost of the other, because 5. F; all countries gain from voluntary trade. -~, each decision requires giving something up. 6. T 7. F; higher prices reduce the quantity demanded. Short-Answer Questions 8. T 1. No, you don't have to give up anything to get air. Yes, you can't have as much clean air as you want 9. T  CHAPTER 1 TEN PRINCIPLES OF ECONOMICS.15 10. T 11. F; a reduction in inflation tends to raIse.~ unemployment. 12. F; a manufacturer should produce as long as the marginal benefit exceeds the marginal cost. 13. F; a single farmer is too small to 'influence the market. 14. T 15. F; workers in the United States have a high standard ofliving because 'they are productive. Multiple-Choice Questions 1. e 2. c 3. b 4. d 5. d 6. c 7. a 8. a 9. b 10. e 11. c 12. a 13. d 14. c 15. b 16. c 17. a 18. d 19. b 20. c Advanced Critical Thinking 1. More students would want to park on campus. 2. It would take much longer to fmd a parking place. 3. No, because we would have to factor in the value of our time spent looking for a parking place. 4. No. Students who could be earning money working are giving up more while looking for a parking place. Therefore, their opportunity cost is higher. I