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Economy - Oikonomos one who manages the household - Households & Economies both face many decisions o Household

d distribution of chores; must allocate scare resources among its various members taking into account each members abilities, efforts and desires o Societies distribution of jobs; allocate people to various jobs and output of goods and services they produce - Resources are scarce o Management of societys resources is important! o Scarcity limited resources, cannot produce all the goods and services people wish to have - Economics o Study of how society manages its scare resources o Allocated by combined actions of millions of households and firms o Study on how people make decisions how people work, what they buy, how much they save and invest o Study on how people interact with each other how buyers and sellers can determine price and qty. of good sold o Study on forces and trends that affect economy as a whole growth in average income, fraction of population that cannot find work, rate at which prices are rising How People Make Decisions - Economy reflects the behavior of individuals who make up the economy - Four principles of Individual Decision Making 1. People Face Trade-offs o There is no such thing as free lunch o To get one thing that we like, we usually have to give up another thing that we like o Decision making: For every hour she spends studying, she gives up an hour for napping o Different Kinds of Trade Off Guns and Butter The more society spends on national defense to protect from foreign aggressors,

the less it can spend on consumer goods to raise standard of living Clean environment vs high level of income Efficiency vs Equality Efficiency society is getting maximum benefits from its scarce resources (size of pie) Equality benefits are distributed uniformly among societys members (how the pie is divided equally into slices) Taxes that aim to help people who are most in need. They ask the financially successful to contribute more that others to support the government. The government redistributes income from the rich to the poor, but it reduces the reward for working hard As a result, while achieving greater equality, these policies reduce efficiency because people tend to work less and produce fewer goods and services. Cut economic pie into more equal slices, the pie gets smaller o People are likely to make good decisions if they understand the options available. 2. The Cost of Something is What you Give Up to Get It o Opportunity Cost what you give up to get that item o College Athletes Opportunity Cost of college is high Millions to play sports vs college Not worth it 3. Rational People Think at the Margin o Rational People Systematically and purposefully do the best they can to achieve objectives given the available opportunities Decisions involve shades of gray o Marginal Change A small incremental adjustment to an existing plan of action Marginal change adjustments around the edges

o Rational People make decisions by comparing marginal benefits and marginal costs Passenger willing to pay $300 for a seat, and the plane has empty seats. Thus, the cost of adding one more passenger is tiny. Though the average cost of flying a passenger is $500, the marginal cost is merely the bag of peanuts the passenger will consume. So as long as the standby passenger pays more than the marginal cost, selling the ticket is profitable o Why is water so cheap, while diamonds are so expensive? Water is a basic need, so why are people willing to pay more for diamonds? Persons willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit depends on how many units a person already has Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. No one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large o A rational decision maker takes an action IF AND ONLY IF the marginal benefit of the action exceeds the marginal cost o One additional airplane ticket low marginal cost o One additional diamond high marginal benefit 4. People Respond to Incentives o Incentive something that induces and motivates a person to act, such as the prospect of a punishment or reward o When the price of apple rises, people decide to eat fewer apples so apple orchards decide to hire more workers and produce more apples. o Public policymakers can control and alter peoples behavior through their policies

Tax on gasoline smaller cars in Europe, carpool, hybrid and electric cars Seat belt law + autosafety, survival rate increases, careful driving with the benefit of increased safety (rational people = marginal benefit greater than marginal cost) Seat belt law - respond to seat belts as improvement of road, so they drive fast and less carefully; larger number of accidents; pedestrian deaths o When analyzing a policy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter behavior. o Incentive Effects of Gasoline Prices Limited supplies + demand = high gas price served as an increased incentive to conserve How People Interact - Our decisions affect not only ourselves, but other people as well 5. Trade Can Make Everyone Better Off o Trade between two countries can make each country better off o Families compete against one another when looking for jobs, but despite this competition, your family would not be better off isolating itself. o Trade allows each person to specialize in the activities he or she does best (farming, sewing, etc) o By trading, people can buy a greater variety of goods and services at lower cost o Countries benefit with trading because it allows each to specialize in what they do best and to enjoy a greater variety of goods and services o Countries = both competitors and partners in economy 6. Markets are usually a good way to organize economic activity

o Communism central planning only government allocated goods and services o Market Economies: economy that allocates resources through decentralized decisions of firms and households as they interact in markets for goods and services o Interaction in marketplace, where prices and self-interest guide decisions o Adam Smith Households and firms interacting in markets act as if they are guided by an invisible hand that leads them to desirable market outcomes o Buyers price on how much to demand; Sellers price on how much to supply o Decisions of buyers and sellers market prices reflect the value of a good to society and the cost to society of making the good o When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hands ability to coordinate decisions of the households and firms o Explains why taxes affect allocation of resources, for they distort prices and decisions of households and firms; explains harm caused by rent control; and failure of communism (planners lacked necessary info about consumers tastes and producers costs) 7. Governments Can Sometimes Improve Market Outcomes o Why do we need the govt if there is the invisible hand? o Invisible hand can only work if the government enforces rules and maintains institutions that are key to a market economy o Need to enforce property rights: ability of individuals to own and control scarce resource o A farmer will not grow food if he expects his crop to be stolen, a company wont produce DVDs if there are too much pirated copies o We rely on government to enforce our rights over the things we produce as the invisible hand counts on our ability to enforce our rights

o Invisible is powerful but not omnipotent; there is a need for government intervention to decide whether they want to promote efficiency or promote equality o Efficiency Invisible hand leads markets to allocate resources to maximize the size of economic pie Market failure = market fails to produce an efficient allocation of resources Caused by an externality or the impact of ones persons actions on the well being of a bystander (ex: pollution) Caused by market power or the ability of a single person to unduly influence market prices (ex: abusive owner of well) o Equality Invisible hand can leave sizable disparities in economic well being A market economy rewards people according to their ability to produce things that other people are willing to pay for Ex: Basketball player earns more than chess player because people like to watch basketball more Invisible hand does not ensure that everyone has sufficient food, decent clothing and adequate health care Government enters: public policies, income tax system aims to achieve equal distribution of economic well being o Government can improve, but does not mean they will Policies to reward politically powerful Not informed but well intentioned leaders How the Economy as a Whole Works - All decisions and interactions together make up the economy 8. A Countrys Standard of Living Depends on Its Ability to Produce Goods and Services o Variation in living standards are attributable to differences in countries productivity: amount of goods and services produced from each unit of labor input

o Nations with workers who can produce a large quantity of goods and services per unit of time high standard of living o Growth rate of a nations productivity determines the growth rate of its average income o Productivity primary determinant of living standards o Productivity and living standards public policy 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 9. Prices rise when the government prints too much money o Inflation: an increase in the overall level of prices in the economy o What causes inflation? o GROWTH IN THE QUANTITY OF MONEY o When the government creates large quantities of money, the value of money falls 10. Society faces a short-run trade-off between inflation and unemployment o Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services o 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 o More hiring means lower unemployment o Short run trade off: inflation and unemployment o Key role in analyzing the business cycle: irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed o Policymakers exploit short run tradeoff by using policy instruments By changing the amount the government spends, the amount it taxes and the amount of money it

prints, policymakers can influence the overall demand for goods and services Changes in demand influence combination of inflation and unemployment o Obamas presidency deep economic downturn Thought of ways to increase overall demand for goods and services Package of reduced taxes and increased government spending Federal Reserve increased supply of money Goal: Reduce unemployment Fear: inflation