Chapters One and Two Notes, Introduction Summary
Chapters One and Two Notes, Introduction Summary Econ 1011
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Econ 1011 First Principles 831 Chapter 1 Introduction A All economic analysis is based on a set of common principles that apply to many different issues B Individual choice the choices individuals make 1 Making a choice among a limited number of options limited because no one can have everything heshe wants 2 We make decisions in an environment shaped by the decisions of others C In order to understand how market economies work we must understand economic interaction 1 Economic interaction how my choices affect you choices D Every economic issue involves individual choice decisions by an individual about what to do and what not to do Principle 1 Choices Are Necessary Because Resources Are Scarce A You can t always get what you want 1 Limited time and money keep people from having everything they want B People must make choices because resources are scarce C Resource anything that can be used to produce something else 1 Land 2 Labor 3 Caphal 4 Human capital D Resources are scarce when there s not enough resources available to satisfy all the ways in which society wants to use it Principle 2 The True Cost of Something Is Its Opportunity Cost A Opportunity cost what you must give up in order to get an item you want 1 All costs are opportunity costs B The opportunity cost of an item what you must give up in order to get it is its true cost Principle 3 How Much Is a Decision at the Margin A Some important decisions involve an quoteither orquot choice other important decisions involve quothow muchquot choices 1 Tradeoff a comparison of costs and benefits B Marginal decisions whether to do a bit more or a bit less of an activity like what todo with your next hour your next dollar etc C How much decisions require making tradeoffs at the margin comparing the costs and benefits of doing a little bit more of an activity versus doing a little bit less D Marginal analysis study of such decisions quothow muchquot decisions 1 Marginal analysis is the key to deciding quothow muchquot of an activity to do Principle 4 People Usually Respond to Incentives Exploiting Opportunities to Make Themselves Better Off A Incentive an opportunity to make themselves better off 1 Individuals will continue to to exploit these opportunities until they have been fully exhausted 2 The principle that people will exploit opportunities to make themselves better off is the basis off all predictions by economics about individuals behavior Econ 1011 First Principles 831 Chapter 1 B People usually respond to incentives exploiting opportunities tomato themselves better off VI Interaction How Economies Work A An economy is a system for coordinating productive activities of many people B Interaction my choices affect your choices 1 The end result of individual choices may be very different than what any one individual intends VII Principle 5 There Are Gains from Trade A Trade people divide tasks among themselves and each person provides a good or service that other people want in return for different goods and services that heshe wants B Gains from trade by dividing tasks and trading two people can both get more of what they want than they could get by being selfsufficient C There are gains from trade D Specialization a situation in which different people each engage i a different task specializing in those tasks that they are good at performing 1 The economy as a whole can produce more when each person specializes in a task and trades with others VIII Principle 6 Market Move Toward Equilibrium A Equilibrium a situation in which individuals cannot make themselves better off by doing something different B Because people respond to incentives markets move towards equilibrium 1 Any time there is a change the situation will move towards equilibrium IX Principle 7 Resources Should Be Used Efficiently to Achieve Society s Goals A The measure that economists really care about is not money but people s happiness or welfare B And economy s resources are used efficiently when they are used in a way that has fully exploited all opportunities to make everyone better off C An economy is efficient when it take all opportunities to make some people better off without making other people worse off 1 An economy is producing the maximum gains from trade possible given the resources available 2 There is no way to rearrange how resources are used in a way that can make everyone better off D Resources should be used as efficiently as possible to achieve society s goals 1 Efficiency is only a means to achieving society s goals 2 Sometimes efficiency may conflict with a goal that society has deemed worthless to achieve E Equity fairness 1 Policies that promote equity come at a cost of decreased efficiency in the economy 2 There is a conflict between efficiency and equity X Principle 8 Markets Usually Lead to Efficiency A In a market economy people normally take opportunities for mutual gain gains from trade B Because people usually exploit gains from trade markets usually lead to efficiency Econ 1011 First Principles 831 Chapter 1 C Market failure the individual pursuit of self interest found in markets makes society worse off that is the market outcome is inefficient XI Principle 9 When Markets Don t Achieve Efficiency Government Intervention Can Improve Society s Welfare A When markets don t achieve efficiency government intervention can improve society s welfare 1 An appropriately designed government policy can move society closer to an efficient outcome by changing how the resources are used B Three principle ways in which they fail 1 Individual actions have side effects that are not taken into account by the market 2 One party prevents mutually beneficial trades from occurring in an attempt to keep more of the resources for itself 3 Some goods are unsuited for efficient management by markets XII Principle 10 One Person s Spending Is Another Person s Income A One person s spending is another person s income B If some group in the economy decides to spend more the income of others will rise 1 If some groups decides to spend less the income of others will fall C Chain reaction of changes in spending behavior tends to have repercussions that spread through the economy XIII Principle 11 Overall Spending Sometimes Gets Out of Line with the Economy s Productive Capacity A Overall spending sometimes doesn t match the amount of goods and services the economy is capable of producing B Shortfalls in spending are responsible for most though not all recessions 1 It is also possible for spending to be too high 2 In this case the economy experiences inflation a rise in prices throughout the economy C Overall spending sometimes gets out of line with the economy s production capac y XIV Principle 12 Government Policies Can Change Spending A Government policies can change spending B Macroeconomic policy government spending taxes and control of money 1 These tools are deployed by the government in order to manage overall spending in the economy Econ 1011 Economic Models 92 Chapter 2 Tradeoffs and Trade I Introduction A Model a simplified representation of the real thing that can be used to answer crucial ques ons 1 Plays a crucial role in almost all scientific research economics included 2 Economic theory consists mainly of models ll Models in Economics Some Important Examples A Model any simplified representation of reality that is used to better understand reallife shua ons 1 How do we create models B One possibility is to find or create a real but simplified economy 1 Cigarettes became a universally accepted form of payment in prisons even among prisoners who didn t smoke during WWII C Another possibility is to stimulate the workings of the economy on a computer 1 When tax laws are proposed officials use tax models large mathematical programs to asses how the taxes would affect different types of people D Other things equal assumption all other relevant factors remain unchanged E The most effective form of economic modeling is the construction of thought experimentsquot simplified theoretical versions of reallife scenarios F Economists often use mathematics to clarify an issue 1 Ex a numerical example a simple equation or a graph a Production possibility frontier a model that helps economists think about the tradeoffs every economy faces b Comparative advantage clarifies the principles of gains from trade both between individuals and countries c Circularflow diagrams schematic representation that helps to understand how the flow of money goods and services is channeled through the economy lll Tradeoffs The Production Possibility Frontier A Resources are scarce and as a result any economy faces tradeoffs B Production possibility frontier improve our understanding of tradeoffs by considering a simplified economy that produces only two goods 1 There is a crucial distinction between points inside or on the production possibility frontier and outside the frontier a If a production point lies inside or on the frontier it is feasible b If a production point lies outside the frontier it isn t feasible 2 Thinking in terms of a production possibility frontier simplifies the complexities of reality C Efficiency an economy is efficient if there is no way to make some people better off without making other people worse off 1 Production possibility frontiers are a good way to illustrate efficiency 2 Efficient in production if the economy as a whole could not produce more of any one good without producing less of another a It is inefficient in production if the economy could produce more of some things without producing less of others 3 Efficient in allocation the economy allocate its resources so that consumers are as well off as possible 4 Efficiency for the economy requires both efficiency in both production and allocation D Opportunity Cost what must be given up in order to get the good Econ 1011 Chapter 2 VI E B Economic Models 92 Tradeoffs and Trade 1 Whenever we assume the opportunity cost of an additional good doesn t change the production possibility frontier is a straight line 2 The slope of a straight line production possibility frontier is equal to the opportunity cost 3 When opportunity costs are increasing rather than constant the production possibility frontier is a bowedout curve 4 Opportunity costs are typically increasing a As more goods are produced its opportunity cost usually rises because well suited inputs are used up and less adaptable inputs must be used instead Economic Growth the growing ability of the economy to produce goods and services 1 An expansion of the economy s production possibilities the economy can produce more of everything 2 In the production possibility frontier model growth is shown as an outward shift of the frontier a One source of growth is is an increase in the economy s factors of production the resources used to produce goods and services 1 Factor of production is used by economists to refer to a resource that is not used up in production 2 Main factors of production are the resources land labor physical capital and human capital b Another source is progress in technology the technical means for production of goods and services Comparative Advantage and Gains from Trade A Gains from trade the mutual gains that individuals can achieve by specializing in doing different things and trading with one another Comparative advantage producing something if the opportunity cost of that production is lower for that country than for other countries 1 Countries will only be willing to trade if the price of the good each country obtains in the trade is less than its own opportunity cost of producing the good domestically The model shows that through specialization and trade both countries produce more and consume more than if they were selfsufficient The model demonstrates the point that each country has a comparative advantage in producing something 1 Everyone has a comparative advantage in something and everyone has a comparative disadvantage in something Absolute advantage when a country can produce more output per worker than other countries 1 Comparative not absolute advantage is the basis for mutual gain Comparative Advantage and International Trade in Reality A B Economists have a very positive view of international trade because they view it in terms of comparative advantage Each country consumes more than if it didn t trade and remained selfsufficient Transactions The CircularFlow Diagram A Barter one party directly trades a good or service for another good or service without money 1 Usually people trade goods or services for money 2 They sell goods or services and buy other goods or services Econ 1011 Economic Models 92 Chapter 2 Tradeoffs and Trade B Circularflow diagram represents the transactions that take place in an economy by two kinds of flows around a circle 1 Flows of physical things such as goods services labor or raw materials in one direction 2 Flows of money that pay for these physical things in the opposite direction Households and firms are illustrated by the simplest circularflow diagram 1 A household consists of an individual or a group of people who share an income 2 A firm is an organization that produces goods and services for sale Markets for goods and services households buy the goods and services they want from firms Factor markets firms buy the resources they need to produce goods and services 1 AKA Labor market workers sell their services Capital market the market in which capital is bought and sold Income distribution how the total income created in an economy is allocated between less skilled workers and the owners of capital and land 1 Determined by factor markets Circularflow diagrams ignore a number of realworld complications 1 The distinction between firms and households isn t always that clearcut 2 Many of the sales firms make are not to households but to others firms 3 The government diverts quite a lot of money out of the circularflow diagram in the form of taxes but also injects it in the form of spending Vll Using Models A B Positive versus Normative Economics 1 Economics is mainly a matter of creating models that draw on a set of basic principles but add more specific assumptions that allow the modeler to apply those principles to a particular situation 2 Positive economics analysis that tries to answer questions about the way the world works which have definite right and wrong answers a Occupies most of the time and effort of the economics profession b Models play a crucial role 3 Normative economics analysis that involves saying how the world should work a Positive economics is about description normative economics is about prescription Forecast a simple prediction about the future 5 Answers to quotwhat ifquot questions often serve as a guide to policy but they are predictions not prescriptions 6 Economic analysis can often be used to show that some policies are clearly better than others regardless of anyone s opinions When and Why Economists Disagree 1 Media coverage tends to exaggerate the real differences in views among economists a If almost all economists agree on an issue the media considers it not worth reporting 2 Economics is unavoidably tied up with politics a Powerful interest groups have an incentive to to find and promote economists who profess those opinions they want to hear b This gives those economists a prominence and visibility out or proportion to their support among their colleagues P Econ 1011 Economic Models 92 Chapter 2 Tradeoffs and Trade 3 Many economists argue whether or not the government should replace the income tax with a value added tax a national tax which is the main source of government tax in any European countries 4 Another difference comes from economic modeling a Two economists can disagree about which simplifications are appropriate and therefore arrive at different conclusions b In most cases like this disputes are resolved by the accumulation of evidence showing which of the models does a better job at of fitting the facts Econ 1011 Introduction 831 I Introduction The Ordinary Business of Life A Economics is the quotstudy of mankind in the ordinary business of lifequot 1 How does our economy system work 2 When and why does our economic system go astray leading people into counterproductive behavior 3 Why are there ups and downs in the economy 4 Why is the long run manly a story of ups rather than downs Why has America become so much richer over time The Invisible Hand 1 Economics is the social science that studies the production distribution and consumption of goods and services 2 The US has a market economy an economy in which production and consumption are the result of decentralized decisions by many firms and individuals a Each individual or firm makes what heshe thinks will be the most profitable b Alternate is a command economy there is a central authority making decisions about production and consumption 1 Soviet Union a Unable to produce because they did not have crucial raw materials b Nobody wanted their products 3 Market economies coordinate highly complex activities and reliably provide consumers with the good and services they want 4 Invisible hand the way a market economy manages to harness the power of self interest for the good of society a quotHe intends only his own gain and he is in this as in many other cases led by an invisible hand to promote an end which was no part of his intentionquot 5 Microeconomics the study of how individuals make decisions and how these decisions interact My Cost Your Benefit 1 Market failure the individual pursuit of one s own interest instead of promoting the interests of society as a whole can actually make society worse off a Economic analysis can be used to diagnose cases of market failure and devise solutions Good Times Bad Times 1 Recessions fluctuations in the economy 2 Macroeconomics concerned with the overall ups and downs of the economy a How economists explain recessions and how government policies are used to minimize the damage from economic fluctuations Onward and Upward 1 Economic Growth the growing ability of the economy to produce goods and services An Engine for Discovery 1 quotEconomics is not a body of concrete truth but an engine for the discovery of concrete truthquot
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