Shivesh KabraAP Economics Summer Notes - Deken

Ten Principles of Economics:

Economics: the study of how society manages its scarce resources

How People Make DecisionsI. People face Trade-offs

a. “There is no such thing as a free lunch”i. Ex. Every time you do something, you give up the

opportunity to do something else.ii. In society there is a trade off between guns (national

defense) and butter (consumer goods/ standard of living)

iii. Laws which require pollution control increase cost of production of goods

b. Two goals of gov’t policy (often conflict)i. Efficiency: the degree to which society is getting the

maximum benefit from it’s scarce resources (size of economic pie)

ii. Equity: the degree to which those benefits are being distributed among the society (how economic pie is divided)

iii. When the government penalizes the wealthy for being wealthy, they lose incentive to keep working

II. Cost is determined by what you give up to get ita. Decision-makers have to consider both the direct and

implicit consequences of their actionsb. Aside from financial cost, there are other things being

given up for a good or servicei. Ex. College – You pay for room, tuition, etc for

intellectual enrichment but you also give up time with which you could be doing a number of other things.

1. Additionally, room and board are only a “cost” to the extent that they are more expensive elsewhere.

2. If Room and board is cheaper than basic living and food expenses, then the savings are considered a benefit.

c. Opportunity Cost: whatever must be given up in order to obtain an item

III. Rational people think at the margina. Rational People: people who systematically and

purposefully do the best they can to achieve their objectives, given the opportunities that they have.

i. Companies will choose # of employees and the amount of product to manufacture specifically to maximize profits.

ii. Marginal Changes: small incremental adjustments to a plan of action.

b. A rational decision-maker takes action if and only if the marginal benefit of the action exceeds the marginal cost.

i. Ex. A stand-by passenger being added to a flight with empty seats who is paying less than the average cost of the flight; the airline, though not charging as much is taking advantage of the fact that there is another person willing to pay for the tiny cost for peanuts/soda.

ii. Kobe Bryant skipped college for a $10 M contract right out of high school

c. The rarer an item, the greater the marginal benefit is considered to be.

IV. People respond to incentivesa. Incentive: something (such as the prospect of a

punishment or a reward) that induces a person to act. CRUCIAL to public policy

b. “People respond to incentives. The rest is commentary”i. People respond when costs and/or benefits change

1. Ex. When the cost of an apple rises, people eat pears to save money but apple orchards still hire more workers to harvest apples because the benefits of selling are also higher (when cost is up)

2. Ex. Tax on gas makes people want to drive cars with better mileage

ii. NOTE: Incentives are direct effects of various stimuli, but many incentives are also implicated.

How People InteractV. Trade can make everyone better off

a. Rather than being self-sufficient, people can specialize in producing one good or service in exchange for other goods

b. Competition results in gains from trading as people continue to develop better products to develop a larger base of customers

c. Specialization allows people to specialize in what they do best.

d. Countries also benefit from trade/ specialization: i. Get better prices abroad for goods they produceii. Buy other goods more cheaply from abroad than

could be produced at home

VI. Markets are usually a good way to organize economic activitya. Market Economy: an economy that allocates resources

through the decentralized decisions of many firms and households as they interact in markets for goods and services. Prices and self-interest regulate the economy in a way that promotes overall economic well being.

i. Adam Smith in Wealth of Nations mentions an “invisible hand”

ii. Buyers look at price to determine how much to demand; sellers look at price to determine how much to supply.

b. When the government regulates prices from adjusting naturally to supply and demand the “invisible hand” no longer works

i. Thus taxes adversely affect the allocation of resources by distorting prices (and the decisions of households and firms)

1. The USA is not truly Laizzes-Faire (“Hands Free” or Free Market Economy) though it is decentralized.

VII. Governments can sometimes improve market outcomesa. Property Rights: The key to a successful market: the ability

of an individual to own and exercise control over scarce resources.

i. Government is key in a Market because it has to enforce property rights.

ii. Government has policies which try to either promote equity or efficiency

b. Market Failure: When the ‘invisible hand’ fails to produce an efficient allocation of resources.

i. Externality: a cause of Market Failure; the impact of a person’s actions on the well being of a bystander (Ex. Pollution)

ii. Market Power: another cause of Market Failure; the ability of a single economic actor (or a small group of

actors) to have substantial influence on market prices. WHY TRUSTS WERE BANNED; ROBBER BARONS

c. The ‘invisible hand’ rewards people based on their ability to produce things that people are willing to pay for.

i. Doesn’t ensure all necessities of life to everyone. Thus social welfare and income tax were created.

d. Policies are designed by an imperfect system, often favoring certain individuals.

How The Economy As a Whole WorksVIII. A country’s standard of living depends on it’s productive

outputa. Productivity: the quantitative of goods and services

produced from each hour of a worker’s time.i. Higher productivity means more money circulating in

the economy and thus a higher standard of living.b. Policy makers always consider how their policies will affect

production levels.

IX. Prices rise when the government prints too much $a. Inflation: an increase in the overall level of prices in the

economy. (20th Century Germany Post-WWI)b. If there is too much money, the value of money falls—as a

result the prices shoot up.c. Policy makers try to keep inflation to a minimum.

X. Society faces a short-term trade off between inflation/unemployment

a. Short-term effects of printing money:i. Increasing the amount of money stimulates the

overall level of spending and thus the demand for goods and services.

ii. Higher demands may cause firms to raise prices but also encourages them to increase quantities so they hire more people

iii. More hiring = less unemploymentb. Policymakers face this tradeoff, though it can be optimized

and there can be better outcomes than others.c. Business Cycle: the irregular and largely unpredictable

fluctuations in economic activity, as measured by the production of goods and services or the number of people employed.