Chapter 1

Three Key Economic Ideas:

A. People are rational
B. People respond to economic incentives
C. Optimal decisions are made at the margin
A. People are Rational
- Economists assume that people are rational
- Assume means that economists assume that consumers and firms use all available info
as they act to achieve their goals.
( E.g. microsoft analyzed all their info and came to a conclusion that $239 is the
price to go)
- Rational individuals weigh the benefits and costs of each actiona, and they choose an
action only if the benefits outweigh the costs
B. People Respond to Economic Incentives
- FBI example - it is more costly to implement new security measures than it is deal with
robberies.
Incentive - something that incites or tends to incite to action or greater effort, as a reward offered for
increased productivity.
C. Optimal decisions are made at the margin
- Marginal means extra or additional.
E.g. Whenever we choose to watch tv or do hw, we have a marginal benefit and a marginal cost.
- If we choose to watch tv, the marginal benefit is that we gain entertainment but the cost
is that we receive a lower grade as a result of not doing hw.
- In business sceanarios, firms have to make careful calculations to determine whether
the additional revenue received from increasing production is greater or less than the additional cost of
the production.
- Economists refer to analysis that involes cpmparing marginal benefits and marginal costs as
marginal analysis.
1.2 The Economic Problem That Every Society Must Solve
- Every society faces trade-offs: Producing more of one good or service means producing less of
another good or service.
- The oppertunity cost of any activity -- such as producing a good or service -- is the highest-valued
alternative that must be given up to engage in that activity.
Trade-offs force society to make choices when answering the following three fundamental questions:
1. What goods and services will be produced?
- The answer is determined by the choices that consumers, forms, and the government make.
- COnsumers, firms, and govt face the problem of scarcity by trading off one good or service for

another.
2. How will the goods and services be produced?
- Firms choose how to produce the goods and services they sell.
- In many cases, firms face a trade off between using more workers or using more machines.
3. Who will receive the goods and services produced?
In the US who receives the goods and services produced depends largely on how income is
distributed.
- Distribution of income is more equal now because the rich pay a larger percentage of their
income in taxes.
Central vs market economies
Efficiency and Equity
Efficiency - whenever we get the maximum output of a given input
- Two types of efficiency:
Productive efficiency occurs when a good or service is produced at the lowest possible cost.
- This can be achieved when competition among firms in markets forces the firms to
produce goods and services at the lowest cost.
Allocative efficiency occurs when production is in accordance with consumer preferences.
- This can be achieved when the combination of competition among firms and voluntary
exchange between firms and consumers results in forms producing the mix of goods and services that
consumers prefer the most
- Markets tend to be efficient because they promote competition and facilitate voluntary exchange.
- Voluntary exchange - a situation that occurs in markets when both the buyer and seller of a
product are made better off by the transaction.
- We know that the buyer and seller are both made better off by the transaction bc
otherwise the buyer would not agreed to buy the product or the seller would agreed to sell it.
Competition will force firms to continue producing and selling goods and services as long as the
additional benefit to the consumers is greater than the additional cost of production.