Ten Principles of Economics Chapter 1 Ten Principles of Economics Microeconomics Ratna K. Shrestha 1 1 1 1 1 1 1 1

Overview Scarcity and Economics How People Make Decisions How People Interact How the Economy as a Whole Works 2 15 2 15 2 2 2 2

Decisions Who will work? What good and how many to produce? What resources to use? Who will we sell it to and at what price? 5 4 5 4 5 5 5 5

Scarcity... … means that society has less to offer than people wish to have. Managing society’s resources is important because resources are scarce. 6 5 6 5 6 6 6 6

Economics is the study of how society manages its scarce resources What is Economics? Economics is the study of how society manages its scarce resources Economists study. . . …how people make decisions. ...how people interact with each other. …the forces and trends that affect the economy as a whole. 7 6 7 6 7 7 7 7

How People Make Decisions? People face tradeoffs. The cost of something is what you give up to get it. Rational people think at the margin. People respond to incentives. 8 7 9 7 9 9 9 9

To get one thing, we usually have to 1. People face tradeoffs To get one thing, we usually have to give up another thing (a) Guns vs. Butter (b) Food vs. Clothing (c) Leisure Time vs. Work (d) Efficiency vs. Equity 9 8 10 8 10 10 10 10

1. People face tradeoffs Efficiency means . . . …getting the most you can from scarce resources. Equity means . . . …benefits of resources are distributed fairly among society. 10 9 11 9 11 11 11 11

2. The Cost of Something Is What You Give Up to Get It Decisions require comparing costs and benefits of alternatives Going to university vs. going to work Opportunity Cost is what you give up from one alternative (choice) to get what you want (from another choice) What is the opportunity cost of going to university for Hokey Star Joe Sakic? What is the Opportunity Cost of Econ 310? 11 10 12 10 12 12 12 12

3. Rational People Think at the Margin Marginal changes are small, incremental adjustments to an existing plan of action. Comparing extra benefits and costs of a critical choice such as whether to get a master’s degree or attend one more year of University. Your decision depends on: Marginal Benefits => MB Marginal Costs => MC of such a choice. What are the MB and MC of a MA degree? 12 11 13 11 13 13 13 13

4. People Respond to Incentives Marginal changes in costs or benefits from decisions motivate people to respond. What would you do if the government imposes a tax of $1/lit on gasoline? Fertility rate went up in Quebec between 1988-1997 in response to “baby bonus.” Should the bonus be higher for the first or second baby ? Decision to choose one good over another occurs when MB > MC. 13 12 14 12 14 14 14 14

4. People respond to incentives. LA Laker basketball star Kobe Bryant chose to skip college and go straight to the NBA from high school when offered a $10 million contract. 10

How People Interact? Trade can make everyone better off. Markets are usually a good way to organize economic activity. Government can sometimes improve market outcomes. 15 14 17 14 17 17 17 17

5. Trade Can Make Everyone Better Off Individuals gain from their ability to trade with others. You cannot grow your own food, make your own clothes, and build your own homes. Trade allows one to specialize in what he/she does best and enjoy a greater variety of goods. What does Canada specialize in and what does Canada buy from others? 16 15 18 15 18 18 18 18

6. Markets Are Usually a Good Way to Organize Economic Activity In a Market Economy, households and business firms determine what to buy, who to work for, who to hire and what to produce. Interaction between household and business is as if guided by an “invisible hand.” Households and firms look at prices when deciding what to buy and sell. The puzzle is that in a market economy everybody is guided by his/her own self- interest and yet it promotes overall economic well being. 17 16 19 16 19 19 19 19

7. Governments Can Sometimes Improve Market Outcomes Market failure results in inefficiency - failure of the “invisible hand.” When the market fails the government can intervene to promote Efficiency. Government also intervenes to promote Equity. Oftentimes both efficiency and equity are not obtainable simultaneously. 18 17 20 17 20 20 20 20

7. Governments Can Sometimes Improve Market Outcomes Causes of Market failure Externality, impact of one person’s actions on the well-being of a bystander. Example: Freeway accidents, even if they're off on the side of the road, usually cause traffic jams.  These jams occur because drivers don't take the external cost of their actions (on other drivers) into account when they slow down to take a look.  Other Examples; Pollution, Research, etc.. 19 18 21 18 21 21 21 21

7. Governments Can Sometimes Improve Market Outcomes Market power is the ability of a single person or a small group to unduly influence market prices. (examples: monopoly, Cartel) Asymmetric information, a situation where one party (seller or buyer) has more information than the other party about a product. ex: In the auto insurance market, drivers have information about what kind of drivers (risky or careful) they are but ICBC does not. - In the used car market who has the information about the condition of the car?

7. Governments Can Sometimes Improve Market Outcomes How can the government improve market outcomes? Government can tax or subsidize externality creating activities. For example, Tax pollution, subsidize research. Government can control prices, prevent firms from collusion, or break a big company into smaller firms to foster competition. US government split AT&T into smaller “baby bells” to foster competition in mid 1970s. 19 18 21 18 21 21 21 21

How the Economy as a Whole Works? A country’s standard of living depends on its ability to produce goods and services. Prices rise when the government prints too much money. Society faces a short-run tradeoff between inflation and unemployment. 21 20 24 20 24 24 24 24

8. Standard of living depends on a country’s production. Standard of Living may be measured in different ways (e.g. personal income or total market value of a nation’s production.) Differences in standard of living between countries or even provinces is attributable to the productivity of the country or province. Why Canada’s average per capita income = $28,000 while that of Mexico = $12,000? - Standard of living depends on per capita income, not total income of the country. 22 21 25 21 25 25 25 25

8. Standard of living depends on a country’s production. Productivity is the amount of goods and services produced from each hour of a worker’s time. Higher the Productivity, higher the Standard of Living. So when thinking about how a public policy will affect living standards, the key question is how it affects our ability to produce goods and services. 23 22 26 22 26 26 26 26

9. Prices Rise When The Government Prints Too Much Money Inflation is an increase in the overall level of prices in the economy. One cause of inflation is the growth in the quantity of money. This reduces the value of money. In Germany in Jan 1921, a daily newspaper cost 0.3 mark. In Nov 1922, the same newspaper cost 70,000,000 mark, why? The high inflation in 1970’s in Canada was also associated with oversupply of money. 24 23 27 23 27 27 27 27

Inflation rate in Zimbabwe topped 2.2 million percent in 2008.

10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment This short-run tradeoff is called the Phillips Curve. When govt. reduces the quantity of money, in the long run, prices go down. But in the short run prices are sticky and it reduces the amount people can spend. This in turn causes unemployment. 25 24 28 24 28 28 28 28

10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment With the decrease in money supply, the value of money goes up in the long run (i.e., prices go down) but in the short run, prices remain the same. With less money and unchanged prices, people will buy less. As consumers buy less, producers produce less and employ less people. 25 24 28 24 28 28 28 28

10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment The central bank (for example, the bank of Canada) can increase money supply by printing more notes and coins and using these notes and coin to buy government bonds from the commercial banks or the public. It can reduce the money supply by selling bonds. 25 24 28 24 28 28 28 28