LSBU

A General Introduction to Economics

How people make decisions

Summary

• The fundamental lessons about individual decision-making are that

• People face trade-offs among alternative goals

• Because the behaviour of an economy reflects the behaviour of the individuals who make up the economy, we start our study of economics with four principles of individual decision-making

• The cost of any action is measured in terms of foregone opportunities

• Rational people make decisions by comparing marginal costs and marginal benefits

• Principle 1: People face trade-offs

• People change their behaviour in response to the incentives they face

• The fundamental lessons about interactions among people are that -

• Principle 2: The cost of something is what you give up to get it

• Trade can be mutually beneficial

• Principle 3: Rational people think at the margin

• Markets are usually a good way of coordinating trade among people

• Principle 4: people respond to incentives

• The government can potentially improve market outcomes if there is some market failure

Summary

• The fundamental lessons about the economy as a whole are that -

• Productivity is the ultimate source of living standards

• Money growth is the ultimate source of inflation

• Society faces a short-run trade-off between inflation and unemployment

Principle 1: People face trade-offs

Principle 3: Rational people think at the margin

• In many situations, people make the best decisions by thinking at the margin

• Economists use the term marginal changes to describe small incremental adjustments to an existing plan

• To get one thing we like, we usually have to give up another thing that we also like

• By comparing the marginal benefits and marginal costs, you can evaluate whether the extra is worthwhile

• Making decision requires trading off one goal against another

• This principle is reflected in the production possibility frontier (PPF)

Principle 2: The cost of something is what you give up to get it

Principle 4: people respond to incentive

• Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action

• The opportunity cost of an item is what you give up to get that item.

• Because people make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change

• For most students, the wages given up to attend university are the largest single cost of their higher education

• When analyzing any policy, we must consider not only the direct effects but also the indirect effects that work through incentives

What is Economics?

How the economy as a whole works

• We started by discussing how individuals make decisions and then looked at how people interact with one another

Formal definition

Principles of Economics

What and for Whom?

• Economics is a science which studies human behavior as a relationship between ends and scarce means, which have alternative uses (Lionel Robbins, 1932).

• Although the study of economics has many facets, the field is unified by several central ideas

• Should we produce guns or butter - What to produce?

• These principle ideas can be grouped into three main categories -

• Factor endowments helps determine what is produced.

1. How people make decisions

2. How people interact

• The existence of demand guides the choice of what is produced - answers the question of for whom!

3. How the economy as a whole works

What Economics is all about

The economic systems

The sub-fields of economics

• Economy - describes all the economic activity (buying and selling or transactions) that take place in a country or region

• The economics is divided into two main sub-fields -

• Economics is all about 'scarcity' and 'choices'.

• The 'How' aspect of the economic question reflects the structure of the economic system - whether to rely on the market or the government to allocate resources.

• Microeconomics - studies decision-making by households and firms and the interaction among households and firms in the market-place

• The economic system of different countries vary - centrally planned, free-market or mixed.

• Because our wants and needs far exceed our ability to satisfy those needs (because of scarcity), society has to decide (choose) what goods and services can be produced, who should produce them and who should benefit from that production.

• Markets may be classified into the following types -

• Macroeconomics - studies the forces and trends that affect the economy as a whole

• Factor markets - for the factors of production

• Goods markets - for goods and services

• So Economics analyzes What, how and for whom society produces

• Macroeconomics covers the fields of International Economics and Development Economics

• Capital markets - for long-term financial capital

How people interact

• All these decisions and interactions together make up 'the economy'.

• The first four principles discussed how individuals make decisions.

• The last three principles concern the workings of the economy as a whole.

• As we go about our lives, many of our decisions affect not only ourselves but other people as well

• Principle 8: An economy's standard of living depends on its ability to produce goods and services

• Principle 9: Prices rise when the government print too much money

• The next three principles concern how people interact with one another.

• Principle 10: society faces a short-run trade-off between inflation and unemployment

• Principle 5: Trade can make everyone better off

Principle 10: society faces a short-run trade-off between inflation and unemployment

Principle 8: An economy's standard of living depends on its ability to produce goods and services

• Principle 6: markets are usually a good way to organise economic activity

Principle 9: Prices rise when the government prints too much money

• when the government increases the amount of money in the economy, one result is inflation.

• Almost all variation in living standard is attributable to differences in countries' productivity - that is, the amount of goods and services produced from each hour of a worker's time!

• Another result, at least in the short run, is a lower level of unemployment.

• Inflation: an increase in the overall level of prices in the economy. Causes money to not act as a good store of value.

• Principle 7: Governments can sometimes improve market outcomes

Principle 7: Governments can sometimes improve market outcomes

Principle 5: Trade can make everyone better off

Principle 6: Markets are usually a good way to organize economic activity

• Although the invisible hand usually leads markets to allocate resources efficiently, that is not always the case

• Countries as well as families benefit from the ability to trade with one another.

• When left on its own, markets often fail: market failure is a situation where scarce resources are not allocated to their most efficient use

• Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services.

• One possible cause of market failure is "externality", which is the uncompensated impact of one person's actions on the well-being of a bystander.

• Market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services