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Econ 10A, Chapter One Notes

by: Devon Black

Econ 10A, Chapter One Notes Econ 10A

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Devon Black
Harvard University

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Covers the ten principles of economics
Principles of Economics
N. Gregory Mankiw
Class Notes
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This 5 page Class Notes was uploaded by Devon Black on Sunday August 28, 2016. The Class Notes belongs to Econ 10A at Harvard University taught by N. Gregory Mankiw in Fall 2016. Since its upload, it has received 7 views. For similar materials see Principles of Economics in Economics at Harvard University.

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Date Created: 08/28/16
Principles of Economics, 6 thEd. Chapter One: Ten Principles of Economics I) Introduction A) Economists study how people make decisions because how society manages its resources is decided by all of the households and businesses in that society 1) They also analyze forces and trends that affect the big picture of the economy II) How People Make Decisions A) Principle 1: People Face Trade-offs 1) To get something, you have to give something (a) If there are 24 hours in a day, and you spend “x” amount of hours studying, then every additional hour you spend studying is an hour fewer that you spend eating, sleeping, or having fun. In this scenario, you judge how important each of these activities are to you and are trading hours of one activity for hours of another 2) Classic trade-off: guns and butter (a) The more money a government spends on its defense and state departments (i.e. departments that focus on foreign assets), the less money it can spend on domestic projects, such as social security and healthcare 3) Pollution vs. Profit (a) Laws that require businesses to produce less pollution raises costs for that company, therefore lowering its profit (b) Less pollution  better health (c) More profit  increased incomes 4) Efficiency vs. Equality (a) All efficiency would be pure capitalism. Mankiw compares this to the size of the pie. More efficiency means lots more money but only for a small portion of the people (b) All equality would be pure socialism. Mankiw compares this to the size of the pieces of the pie. (c) Political Bias: In this section, Mankiw shows that he fiscally leans right by saying that redistribution makes people work less because they don’t get all of their money and therefore don’t see a reward or reason to work as much as they did before. In this way, he pits efficiency against equality B) Principle 2: The Cost of Something Is What You Give Up to Get It 1) Opportunity cost is not just what money you spend to do something, it’s the cost of your time, energy, or potential earnings elsewhere C) Principle 3: Rational People Think at the Margin 1) Rational people do the best they can with what they have in order to achieve their goals 2) Most decisions are those of marginal change: will you study an extra hour? Will you take an extra slice of pizza? Will you run for one more mile? (a) Marginal benefits and marginal costs = what you gain and lose from a marginal change (b) Water vs. Diamonds (1) Water is essential, yet cheap. This is because the marginal cost of another cup of water is low due to water’s abundance. (2) Diamonds are unessential, yet expensive. This is because the marginal cost of another carat of diamond is high due to diamonds’ scarcity. 3) Rational people will only do something if the marginal benefit is higher than the marginal cost D) Principle 4: People Respond to Incentives 1) Incentives are what causes people to do things (a) A rise in apple prices is an incentive for consumers to buy fewer apples while it is also an incentive for producers to produce more apples (1) “The influence of prices on the behavior of consumers and producers is critical for how a market economy allocates scarce resources” 2) Making policy without considering incentives  unintended consequences (E.g. Ralph Nader’s 1960 book Unsafe at Any Speed) (a) Book  Congress requires seatbelts in new law (b) New law  more seatbelts  higher probability of surviving a car accident (intended consequence) (c) New law  change in the speed and care with which people drive since seatbelts reduce the likelihood of injury and/or death (unintended consequence) (1) Marginal cost = time and energy (2) Marginal benefit = higher probability of surviving a car accident (3) People only drive with increased care and speed when the marginal benefit si greater than the marginal cost (e.g. icy roads) (4) Seatbelts therefore lead to increased accidents when drivers see the marginal cost as greater than the marginal benefit (when road conditions are good) which in turn has an adverse effect on pedestrians, as their likelihood of being in an accident has also increased but they do not benefit from the protection of seat belts (d) 1975 study by economist Sam Peltzman shows that auto-safety laws have habitually resulted in fewer deaths per accident but more accidents on the whole i.e. little net change due to the number of drivers who used to be killed are now reflected in the number of pedestrians III) Case Study: The Incentive Effects of Gasoline Prices A) 2005-2008: gas prices skyrocketed and a bunch of news stories were released showing how gas prices incentivized people 1) Buy smaller cars 2) Take public transportation 3) Buy homes close to train stations 4) Students take more online courses in lieu of in-person courses 5) Economic downturn in 2008 then reduces the price of oil in 2009 IV) In the News: Incentive Play A) Why don’t Chicago buses take shortcuts? 1) Bus drivers are paid by hour or by passenger. With the incentive of paying bus drivers by passenger, bus drivers take these shortcuts, leading to significantly shorter delays but more accidents and passenger complaints from nausea from sudden stops 2) People still take the fastest bus regardless of other incentives (i.e. accidents and nausea) V) How People Interact A) Principle 5: Trade Can Make Everyone Better Off 1) Trade allows people more time in order to specialize in their own fields as well as buy a greater variety of goods and services at a lower cost 2) Trade between countries works with this same principle, of competing with each other for customers but also allowing countries to make better products of a specific type (Cuba, cigars; Japan, cars; China, everything) B) Principle 6: Markets Are Usually a Good Way to Organize Market Activity 1) Communism is based on the premise that government officials were in the best position to allocate the country’s scarce resources (central planning) 2) In a market economy, central planners (i.e. the government officials) are replaced by households and businesses (a) Businesses decided whom to hire and what to make while households decide whom to work for and what to buy (b) Prices and self-interest guide their decisions (1) No one looks out for the economy’s well-being as a whole and still somehow succeeds 3) Adam Smith’s Wealth of Nations (1776) and the “Invisible Hand” (a) Leads households and firms interacting in a market economy to make good decisions  desirable market outcomes (b) The invisible hand directs the economy through the fluctuation of prices (1) “market prices reflect both the value of a good to society and the cost to society of making the good” (2) Smith notes that prices increase and decrease in order to impact buyers and sellers and maximize the well-being of society (c) Governments’ fiddling with prices through central planning prevents prices from their natural fluctuations (1) Again shows political bias by saying that taxes distort the actual price of something and therefore distort the decisions of the buyers and sellers C) Principle 7: Governments Can Sometimes Improve Market Outcomes 1) Invisible hand only fully works if the government enforces the rules of the invisible hand and maintains institutions that are necessary to a market economy (a) Most importantly, market economies need governments to enforce property rights so individuals maintain the ability to control and own scarce resources 2) Two reasons for governments to intervene in the economy (a) Promote efficiency (1) Market failure can occur if the government does not intervene (i) Can sometimes be caused by an externality (see definition below) 1. Example of an externality is pollution (ii) Can also be caused market power i.e. a lack of significant economic competition (b) Promote equality (1) Market economies can lead to large inequities in income, so depending on political philosophy, governments can intervene to lessen that income gap VI) FYI: Adam Smith and the Invisible Hand A) Wealth of Nations and Declaration of Independence published in same year and share the same idea that individuals are best left on their own B) Smith asserts the idea that man only helps others when it is beneficial to himself VII) How the Economy as a Whole Works A) Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services 1) Living standards depends on the productivity of the country 2) Growth rate of a country’s productivity determines the growth rate of its average income 3) Public policymakers can raise living standards by ensuring that workers are well educated, have the tools they need to produce goods and services, and have access to the best technology B) Principle 9: Prices Rise When the Government Prints Too Much Money 1) Economic policymakers focus on keeping inflation low 2) Too large of a quantity of money causes inflation C) Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment 1) Short term effects of increasing the quantity of money in society (a) Increases the level of spending and the demand for goods and services (b) Higher demand increases prices but also increases the number of workers and production levels (c) Increase in workers means lower unemployment (d) Printing more money is a trade-off between the short term effects of lower unemployment and the long term effects of inflation 2) Short term trade-off of inflation and unemployment is important when economists study business cycles and the unpredictable and irregular changes that occur inside of them 3) By changing the levels of government expenditures, taxations, and money available in society, the government can change the overall demand for goods and services VIII) In the News: Why You Should Study Economics A) Former president of the Dallas Fed (Robert D. McTeer, Jr.) explains why people should study economics B) Useful as you go up the career ladder 1) Disciplined and systematic way of thinking C) Can understand fallacies and unintended consequences 1) Broken window fallacy IX) FYI: How to Read this Book A) Do the practice questions B) Summarize, don’t highlight C) Group study D) Teach people X) Conclusion A) This part is irrelevant Vocabulary Scarcity: the limited nature of society’s resources Economics: the study of how society manages its scarce resources Efficiency: the property of society getting the most it can from its scarce resources Equality: the property of distributing economic prosperity uniformly among the members of society Opportunity Cost: whatever must be given up to obtain some item Rational People: people who systematically and purposefully do the best they can to achieve their objectives Marginal Change: a small incremental adjustment to a plan of action Incentive: something that induces a person to act Market Economy: an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services Property Rights: the ability of an individual to own and exercise control over scarce resources Market Failure: a situation in which a market left on its own fails to allocate resources efficiently Externality: the impact of one person’s actions on the well-being of a bystander Market Power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices Productivity: the quantity of goods and services produced from each unit of labor input Inflation: an increase in the overall level of prices in the economy Business Cycle: fluctuations in economic activity, such as employment and production


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