Chapter 1: First Principles

- Economics: social science that studies production, distribution, and consumption of goods and services
o Microeconomics: concerned with how people make decisions and how these decisions interact
o Macroeconomics: concerned with overall ups and downs in economy
- Economy: system for coordinating society’s productive activities
o Market economy: decisions about production and consumption are made by individual producers
and consumers; individuals engage in trade
o Market failure: when individual pursuit of self-interest leads to bad results for society
o Recession: downturn in economy
o Economic growth: growing ability of economy to produce goods and services; increase in capacity
for economy to produce goods/services (focused on production)
- Invisible hand: individual pursuit of self-interest can lead to good results for society as a whole
o Adam Smith, Wealth of Nations (market economy) – based on productivity/how much stuff can be
produced rather than currency (money/gold)
Individual choice: decision by individual of what to do and what not to do; one choice affects another
- People make choices because resources are scarce
- Opportunity cost of an item (what you give up to obtain your choice) is true cost
- Decision making/trade-offs at margin based on doing a bit more versus doing a bit less
- People respond to incentives; exploits opportunities to make themselves better off
Principles:
- Resource: anything that can be used to produce something else; scarce (quantity available not large enough
to satisfy all productive uses)
o Land (gift of nature); labor (time of workers); capital (machines)
o Scarcity: petroleum, lumber, intelligence, water
- Opportunity cost: value of the next best alternative; crucial to understanding individual choice
- Marginal analysis: making trade-offs
o Decisions are not “either-or”, they are “how much”
o Trade-offs: comparison of costs and benefits of doing something
o Marginal decisions: decisions to do more/less of an activity; made at the margin (comparing the
costs and benefits of doing a little bit more rather than a little bit less – eating one more chip;
studying decisions)
- Exploiting opportunities: people exploit opportunities to make themselves better off; responds to incentives
o Incentives: anything that offers rewards to people who change their behavior
Interaction (how economies work): interaction of choices is a feature of most economic situations (one choice
affects the other choice)
- There are gains from trade (allows us to consume more than we otherwise could)
- Because people respond to incentives, markets move towards equilibrium
- Resources should be used as efficiently as possible to achieve society’s goals
- Because people usually exploit gains from trade, markets usually lead to efficiency
- When markets don’t achieve efficiency, government intervention can improve society’s welfare
Principles:
- Gains from trade: people get more of what they want through trade than if they strive for self-sufficiency
o Trade: individuals provide goods/services to others and receive goods/services in return; country
can consume outside its production possibility frontier (PPF) – find mutually beneficial trade based
on comparative advantage
o Specialization: when each person specializes in the task that they are good at performing
- Equilibrium: no individual would be better off doing something different
o When there’s change, economy will move to a new equilibrium
o Stability based on making the best choice they could, given what other people were doing
- Efficiency vs. Equity:
o Efficient: taking all opportunities to make some people better off without making others worse off
o Equity: everyone gets their fair share (not as well-defined concept as efficiency)
- Markets usually lead to efficiency: incentives built into market economy ensures that resources are put to
good use (opportunities to make people better off are not wasted)
o Exception: market failure (individual’s self-interest in capitalism makes society worse off; leads to
inefficient market)
o When markets don’t achieve efficiency or markets fail, government intervention can correct it
 Monopolies: government use Sherman Anti-Trust Act to increase competition in market
- Government intervention can improve society’s welfare:
o Markets fail because:
 Individual actions have effects not considered by market (spillover → water pollution)
 One party prevents mutually beneficial trades from occurring in attempt to capture
greater share of resources for itself (monopoly power)
 Some goods cannot be efficiently managed by markets (public goods)
Economy-Wide Interactions
- One person’s spending is another person’s income
o Economy is linked; changes in spending behavior have consequences throughout economy
(farmer, miller, baker, bread consumer)
o In recession: ↓ business spending ↓ income ↓ consumer spending
- Overall spending sometimes gets out of line with economy’s productive capacity
o Amount of goods/services people want to buy ≠ amount of goods/services economy is capable of
producing (inflation vs. recession)
- Government policies can change spending
o Uses three tools (government spending, taxes, and quantity of money in circulation) that can
greatly impact economy
o Main types of spending:
 Household consumption spending ↓ interest rate ↑ spending
 Import/export spending (net spending)
 Government spending (interstate highways)
 Business spending