Principle 1 People face tradeoffs: There was a king who wanted to collect the whole knowledge of the world

d so that others can also be benefitted. He asked Pundits of his kingdom to work on the same and collect the whole knowledge. After several months of hard work the pundit came with seven big books. The king was not satisfied because he felt that nobody will have time to read seven big books for acquiring knowledge. So he ordered the pundits to concise the same. After some time the pundits entered with one big book. Still the king was not satisfied so he again ordered the pundits to concise the same. Now they abridge the knowledge in several pages. But still king felt that it is not enough. Again the pundits after much hard work concise the same to just one page. As usual the king was not very happy and sent pundits again to shorten the knowledge. Now after very much toil pundits were able to concise the wisdom of world in just one sentence. The sentence was, Nothing comes for free. Summary: 10 principles: How people make decisions. 1. People face tradeoffs. (nothing comes for free) 2. The cost of something is what you give up to get it. (always there is opportunity cost) 3. Rational people think at the margin. (Small incremental adjustments. Marginal benefit should be greater than marginal cost) 4. People respond to incentives. How people interact with each other. 5. Trade can make everyone better off. 6. Markets are usually a good way to organize economic activity. (invisible hand) 7. Governments can sometimes improve economic outcomes. (in case there is market failure which occurs due to externality or market power) The forces and trends that affect how the economy as a whole works. 8. The standard of living depends on a countrys production. (productivity of a country) 9. Prices rise when the government prints too much money. (inflation) 10. Society faces a short-run tradeoff between inflation and unemployment. (Philips curve) Chapter 1 Questions for review 1. Give three examples of important tradeoffs that you face in your life. i. We have to compromise on study if we want to play. ii. If I want to buy books I will not be able to buy more clothes. iii. If there is a family function and my presence is required, I cannot join party of a friend. 2. What is the opportunity cost of seeing a movie? Opportunity cost for seeing a movie can be study, play or spending time with family or friends. 3. Water is necessary for life. Is the marginal benefit of a glass of water large or small? Marginal benefit of a glass of water under normal conditions is small because water is available in large quantity but if we are passing through a desert and about to die without water, we would be ready to pay any amount for a glass of water. In this case, its marginal benefit will be large. 4. Why should policymakers think about incentives? Public policymakers should think about incentives because many policies change the costs or benefits that people face and, therefore, alter behaviour. For example by

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increasing price of electricity government can lead people to use more of solar energy. Why isnt trade among countries like a game with some winners and some losers? No country in itself is sufficient to produce everything it needs by itself. If a country isolates itself from international trade, it will be difficult to produce all products domestically and the cost of production and prices will be high. In case of international trade countries will product those goods and services where it has higher efficiency, thus producing goods and services cheaply. Here, competition helps both the countries getting products at cheaper rate. Thus, both the countries will have a win-win situation in case of trade among countries. What does the invisible hand of the marketplace do? Adam Smith is saying that participants in the economy are motivated by selfinterest. People think about increasing their welfare. This thinking serves as invisible hand. This invisible hand of the marketplace guides the self-interest into promoting general economic well-being. Explain the two main causes of market failure and give an example of each. Two main causes of market failure are externalities and market power or monopoly Externalities: Externality means impact of one person of firms actions on other person or society. When a bank does not have strict rules for advancing loan to applicants, the number of defaulters will increase, which in turn will affect the deposit holders in case the bank files for bankruptcy, here government can intervene in functioning of such bank and can save it from bankruptcy. As a positive effect, if a businessman wants to start a new plan which will give employment to many people, government can provide land and other facilities at cheaper rate to the businessman. Why is productivity important? Productivity is the rate at which goods are being produced. Productivity is important because it decides the difference between living standard among different countries. In nations where productivity is high, most people enjoy a high standard of living; in nations where workers are less productive, standard of living is low. Similarly, the growth rate of a nations productivity determines the growth rate of its average income. What is inflation, and what causes it? Inflation means an overall increase in the level of prices over a specific period of time. Growth in the quantity of money is the main cause for inflation. How are inflation and unemployment related in the short run? In the short run there is a trade-off between inflation and unemployment. They both move in opposite direction. If government takes steps to decrease unemployment, increased employment will lead to increased income and increased quantity of money which will lead to increase in inflation. On the other hand if government takes steps to decrease inflation, the quantity of money and spending will decrease. This will lead to decrease in production and layoffs resulting into increased level of unemployment.