CHAPTERS 1 Ten Principles of Economics Economy

CHAPTERS 1 Ten Principles of Economics

Economy. . . Origin: The word “economy” comes from a Greek word for “one who manages a household. ” Definition: Economics is the study of how society manages its scarce resources. (Mankiw & Taylor, 2 nd ed. ) Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses. (Lionel Robbins, 1932) Copyright © 2010 Cengage Learning

Decisions… • An individual faces many decisions: üShould I work? If yes, how much? üWhat goods & how many of them should I purchase? • A society faces many decisions: üWhat goods should be produced? üWhat resources should be used in production? üAt what price should the goods be sold? Copyright © 2010 Cengage Learning

Microeconomics and Macroeconomics • Microeconomics focuses on the individual parts of the economy. • How households and firms make decisions and how they interact in specific markets • Macroeconomics looks at the economy as a whole. • Economy-wide phenomena, including inflation, unemployment, and economic growth Copyright © 2010 Cengage Learning

Scarcity and Choices Society and Scarce Resources: • The management of society’s resources is important because resources are scarce. • Scarcity. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have. • Hence, scarcity forces individuals and the society to make choices. Copyright © 2010 Cengage Learning

TEN PRINCIPLES OF ECONOMICS • How people interact with each other? • Trade can make everyone better off. • Markets are usually a good way to organize economic activity. • Governments can sometimes improve economic outcomes. Copyright © 2010 Cengage Learning

Principle #1: People Face trade-offs. Measurement of Trade-offs: To get one thing, we usually have to give up another thing: • Guns v. butter • Food v. clothing • Leisure time v. work Making decisions requires trading off one goal against another. Copyright © 2010 Cengage Learning

Principle #2: The Cost of Something Is What You Give Up to Get It. • Decisions require comparing costs and benefits of alternatives. • Whether to go to university or to work? • Whether to study or go out on a date? • Whether to go to class or sleep in? • The opportunity cost of an item is what you give up to obtain that item. Copyright © 2010 Cengage Learning

Principle #3: Rational People Think at the Margin. • Marginal changes are small, incremental adjustments to an existing plan of action. How many bottles of water to buy? 0, 1, 2, etc. People make decisions by comparing costs and benefits at the margin. Copyright © 2010 Cengage Learning

Principle #4: People Respond to Incentives. • Marginal changes in costs or benefits motivate people to respond. ü Discounts and promotions üTaxes or subsidies üLaws and regulations • The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs! Copyright © 2010 Cengage Learning

Principle #5: Trade Can Make Everyone Better Off. • People gain from their ability to trade with one another (exploitation of the differences in opportunity costs). • Competition results in gains from trading. • Trade allows people to specialize in what they do best. Copyright © 2010 Cengage Learning

Principle #6: Markets Are Usually a Good Way to Organize Economic Activity. • A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. üHouseholds decide what to buy and who to work for. üFirms decide who to hire and what to produce. üPrice and quantity traded sends a signal to the firms and households in the market. Copyright © 2010 Cengage Learning

Principle #6: Markets Are Usually a Good Way to Organize Economic Activity. • Adam Smith made the observation that households and firms interacting in markets act as if guided by an “invisible hand”. “It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest. ” Copyright © 2010 Cengage Learning

Principle #7: Governments Can Sometimes Improve Market Outcomes. • Market failure occurs when the market fails to allocate resources efficiently. • Market failure may be caused by • an externality, which is the impact of one person or firm’s actions on the well-being of a bystander. • market power, which is the ability of a single person or firm to unduly influence market prices. • When the market fails government intervention can promote efficiency and equity. Copyright © 2010 Cengage Learning

Principle #8: The Standard of Living Depends on a Country’s Production. • Production Income Consumption • Income Consumption Saving • Saving Investment Production (future) • Economic growth - the increase in the amount of goods and services in an economy over a period of time Copyright © 2010 Cengage Learning

Principle #9: Prices Rise When the Government Prints Too Much Money. • Inflation is an increase in the overall level of prices in the economy. • Nominal vs Real: What can we purchase with our income? I=$100 with P 0=$10 vs P 1=$1 • When the government creates large quantities of money, the value of the money falls. Copyright © 2010 Cengage Learning

Principle #10: Society Faces a Short-run trade-off Between Inflation & Unemployment. • Time periods: Short-run (SR) vs Long-run (LR) • Different consequences of an action in time, Present (SR) vs Future (LR): Consumption & Saving (Today) vs Consumption (Tomorrow) • Dynamic Trade-offs: Today vs Tomorrow Copyright © 2010 Cengage Learning

CHAPTERS 2 Thinking Like and Economist Copyright © 2010 Cengage Learning

Scarcity and Choices Society and Scarce Resources: • The management of society’s resources is important because resources are scarce. • Scarcity. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have. • Hence, scarcity forces individuals and the society to make choices. Copyright © 2010 Cengage Learning

Anatomy of Choices Economists assume that people are rational: ü they have well-defined goals, ü and try to achieve their goals as best as they can with available resources and information. People have to make two interrelated decisions: 1) Should they do an action? Yes or No 2) If the answer to the first question is yes, how much? Rational people behave according the following rule: Do activity x if B(x) ≥ C(x) “Take an action if, and only if, the benefits from taking the action are at least as great as the costs. ” Copyright © 2010 Cengage Learning

Identification of costs Measuring the costs & benefits of an action is not always very easy. Sunk costs People sometimes count costs that should be ignored. Opportunity cost People sometimes ignore costs that should be counted, mostly implicit costs. Copyright © 2010 Cengage Learning

Sunk Costs Sunk costs ü Sunk costs are borne whether or not an action is taken. ü It is an expenditure that you cannot recover. ü Therefore, they are irrelevant to a decision on whether to take an action. ü Failure to ignore sunk costs could lead to suboptimal choices! Also known as “Sunk Cost Fallacy” http: //www. youtube. com/watch? v=vpnxd 31 y 0 Fo http: //youarenotsosmart. com/2011/03/25/the-sunk-costfallacy/ Copyright © 2010 Cengage Learning

Opportunity Cost ü Opportunity cost of an action is the value of the nextbest alternative that we must give up in order to engage in that action ü The cost of something is what you give up to get it “There is no free lunch!” ü Making a rational decision requires the recognition of opportunity cost. Copyright © 2010 Cengage Learning

Copyright © 2010 Cengage Learning

Copyright © 2010 Cengage Learning

The Opportunity Cost question ü You won a free ticket to see an Eric Clapton concert (which has no resale value). ü Bob Dylan is performing on the same night and is your next-best alternative activity. ü Tickets to see Dylan cost $40. You would be willing to pay up to $50 to see Dylan. ü There are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? A. $0 B. $10 C. $40 D. $50 Copyright © 2010 Cengage Learning

Why is B. $10 the correct answer? ü When you go to the Clapton concert, you give up the $50 of benefits you could get from the Dylan concert. ü But the Dylan concert costs $40 (ticket price). ü The value (net benefit) of the Dylan concert is $10. ü This is what you give up if you go to the Clapton concert. ü The opportunity cost of the Clapton concert is $10 the net benefit of the second best alternative. Copyright © 2010 Cengage Learning

Choices… • How people make decisions (choices)? • People face scarcity and trade-offs. • The cost of something is what you give up to get it (Opportunity Cost): “There is no free lunch!” • Rational people think at the margin. • People respond to incentives/disincentives. Copyright © 2010 Cengage Learning

Two main ideas: 1. People respond to incentives 2. Rational people think at the margin

People respond to incentives

Implication of Rationality People compare costs and benefits when they decide what to do. [do activity x if B(x) ≥ C(x)] So, if the costs or the benefits of an action change, rational people change their behavior. Economists capture this point by saying that “people respond to incentives”. Copyright © 2010 Cengage Learning

Incentive: definition An incentive is something • that induces a person to act. • such as the fear of punishment or the expectation of reward, that induces action or motivates effort. People respond to many different types of incentives: ü a sense of duty in a community, ü financial/monetary incentives. Copyright © 2010 Cengage Learning

Simple story The price of an apple rises: People decide to eat fewer apples (and possibly more pears) because … …the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples, because… … the benefit of selling an apple is higher. Copyright © 2010 Cengage Learning

Now something completely different: Traffic safety Ø How does a mandatory seat belt law affect auto safety? ü The direct effect is obvious. ü Seat belts increases the chances of survival a major auto accident. ü In this sense, seat belts save lives. Ø But that's NOT THE END of the story. To fully understand the effects of this law, we must recognize that people change their behavior in response to the incentives they face. Copyright © 2010 Cengage Learning

The relevant behavior: The speed & care with which drivers operate their cars. ü Driving slowly & carefully is costly, C(x): Requires the driver's time and energy. ü But it also has benefits: B(X): Lower probability of having an accident and higher probability of survival in case of an accident. When deciding how safely to drive, rational people compare the benefit from safer driving to the cost. Copyright © 2010 Cengage Learning

How does the seat belt law changes the cost-benefit calculation of the rational driver? ü Seat belts make accidents less costly: the probability of injury or death. ü Thus, the seat belt law the net benefits to slow & careful driving. Ø When the benefit of an activity is lower, rational people do less of that activity. Seatbelts, or safety features such as airbags, make rational drivers drive less carefully. Copyright © 2010 Cengage Learning

The law of unintended consequences or Bad things happen to good people

Safer cars… ü the number of driver deaths by the probability of survival. üAt the same time, they the number of driver deaths by encouraging reckless behavior. üWhich effect is the greater? Will the # of driver deaths or ? In 1975 Sam Peltzman (University of Chicago) researched this issue. He found that ü The two effects cancel each other out. ü There are more accidents and fewer driver deaths per accident, but the total number of driver deaths is unchanged. ü The number of pedestrian deaths also increase because pedestrians do not benefit from safer cars.

Almost 30 years later, Peltzman’s results were overturned

The Effects of Mandatory Seat Belt Laws on Driving Behavior and Traffic Fatalities by Alma Cohen & Liran Einav. published in 2003 in the Review of Economics and Statistics Abstract: This paper investigates the effects of mandatory seat belt laws on driver behavior and traffic fatalities. Using a unique panel data set on seat belt usage rates in all U. S. jurisdictions, we analyze how such laws, by influencing seat belt use, affect traffic fatalities. Controlling for the endogeneity of seat belt usage, we find that it decreases overall traffic fatalities. The magnitude of this effect, however, is significantly smaller than the estimate used by the National Highway Traffic Safety Administration. Testing the compensating behavior theory, which suggests that seat belt use also has an adverse effect on fatalities by encouraging careless driving, we find that this theory is not supported by the data. Finally, we identify factors, especially the type of enforcement used, that make seat belt laws more effective in increasing seat belt usage. Copyright © 2010 Cengage Learning

A difficult opportunity cost question You won a free ticket to see an Eric Clapton concert (which you can sell for $35, that means the resale value is $35). Bob Dylan is performing on the same night and is your next-best alternative activity. • Tickets to see Dylan cost $40. • You would be willing to pay up to $50 to see Dylan. There are no other costs of seeing either performer. Based on this information, what is the minimum amount (in dollars) you would have to value seeing Eric Clapton for you to choose his concert? Give a short explanation. Copyright © 2010 Cengage Learning

(Monetary) incentives CAN backfire

People respond to incentives The problem with this principle is the naiveté with which we often assume people respond. We assume (based on rational people models) that if you pay people more to do something, they will do more of it, and if you tax something or raise its price, people will do it less. Of course, this is not always how thing are. Copyright © 2010 Cengage Learning

Two examples 1) Daycare in Israel ü A day care center in Haifa, Israel, begins fining parents for late pickups. ü This is to reduce the number of late pickups of children. ü Initially, there was no specific punishment attached to picking up children late, simply an admonition not to do so. ü The provider instituted a small fee (about $3). Copyright © 2010 Cengage Learning

How did the parents respond? The number of late parents doubled. Why? The fine reduces the parents’ ethical obligation to avoid inconveniencing the teachers and makes them think of lateness as simply a commodity they can purchase. Copyright © 2010 Cengage Learning

A very influential book by Richard Titmuss (1970), "Gift Relationship: From Human Blood to Social Policy“ 2) Bucks for (Donating) Blood Offering to pay women for donating blood decreases the number willing to donate by almost half. Letting them contribute the payment to charity reverses the effect. Both examples from Samuel Bowles Harvard Business Review | March 2009 | hbr. org A large experiment in Switzerland in 2008 found that offering lottery tickets increased turnout at blood drives. Copyright © 2010 Cengage Learning

Rational people think at the margin!

Do an activity if B > C is not helpful for decisions like “how many bottle of water to consume? ” What does the rational person do when deciding on the level of an activity (how much/many? ) Copyright © 2010 Cengage Learning

Deciding on the Level of an Activity Rational decision makers compare The additional benefits against additional costs. also called marginal analysis. Marginal Benefit: The increase in total benefit that results from carrying out one additional unit of the activity. Marginal Cost: The increase in total cost that results from carrying out one additional unit of the activity. Copyright © 2010 Cengage Learning

Finding the Optimal Level At a given level, if the marginal benefit is greater than marginal cost (MB>MC): Increase level of the activity If the marginal benefit is less than the marginal cost (MB

Our Second Model: The Production Possibilities Frontier • The production possibilities frontier is a graph that shows… ü the combinations of output that the economy can possibly produce, Ex: computers vs cars ü given the available factors of production, Ex: Labour and Steel ü and the available production technology. Copyright © 2010 Cengage Learning

Figure 2 The Production Possibilities Frontier Quantity of Computers Produced The opportunity cost of an item is what you give up to obtain that item. A 3, 000 B 2, 200 E C 1, 400 Production possibilities frontier D 400 0 400 800 1, 000 Quantity of Cars Produced Cengage Learning Copyright© 2011 South-Western Copyright © 2010

Our Second Model: The Production Possibilities Frontier • Concepts Illustrated by the Production Possibilities Frontier • Efficiency • Trade-offs • Opportunity Cost • Economic Growth Copyright © 2010 Cengage Learning

Figure 3 A Shift in the Production Possibilities Frontier Quantity of Computers Produced 4, 000 3, 000 2, 100 2, 000 0 E A 700 750 1, 000 Quantity of Cars Produced Copyright © 2010 Cengage Learning Copyright © 2011 South-Western

Interdependence Role of Trade for the Turkish Economy GDP (2012) = $ ? billion Current Account: Exports – Imports = ? % of GDP Exports (2012) = ? % of GDP Imports (2012) = ? % of GDP Copyright © 2011 Nelson Education Limited 55 Copyright © 2010 Cengage Learning