WEEK 1 - Chapter 1: 10 Lessons From Economics Flashcards
Where does the word ‘economy’ come from?
It comes from the Greek word for ‘one who manages a household’.
This origin might seem peculiar. But, in fact, households and economies have much in common.
How are households and economies similar?
Both have to make decisions due to scarce resources.
Eg. Who will drive the car today? VS What jobs will be done and who will do them?
Why is the management of society’s resources important?
Scarcity.
What is scarcity?
The limited nature of society’s resources. Therefore society cannot produce all the goods and services people wish to have.
Just as each member of a household cannot get everything he or she wants, each individual in society cannot attain the highest standard of living to which he or she might aspire.
What is economics?
Economics is the study of how society manages its scarce resources.
What do economists study?
Economists, study how people make decisions - how much they work, what they buy, how much they save and how they invest their savings.
Economists also study how people interact with one another - they examine how the buyers and sellers of a good interact to determine the price at which the good is sold and the quantity that is sold.
Finally, economists analyse forces and trends that affect the economy as a whole - including the growth in average income, the fraction of the population that cannot find work and the rate at which prices are rising.
How are resources allocated?
In most societies, resources are allocated through the combined choices of millions of households and firms.
Although the study of economics has many facets, how is it unified?
It is unified by several central ideas. These central ideas are titled the 10 lessons from economics in this book.
What does the behaviour of an economy reflect?
The behaviour of an economy reflects the behaviour of the individuals who make up the economy.
What are the 10 lessons from economics?
- People face trade-offs.
- The cost of something is what you give up to get it.
- Rational people think at the margin.
- People respond to incentives.
- Trade can make everyone better off.
- Markets are usually a good way to organise economic activity.
- Governments can sometimes improve market outcomes.
- A country’s standard of living depends on its ability to produce goods and services.
- Prices rise when the government prints too much money.
- Society faces a short-term trade-off between inflation and unemployment.
Explain the following lesson from economics: People face trade-offs (lesson 1).
You may have heard the saying: ‘There is no such thing as a free lunch’. To get something that we like, we usually have to give up something else that we also like.
Making decisions requires trading off one goal against another.
What are some typical trade-offs?
The classic trade-off between ‘guns and butter’:
⬆️$ to defence = ⬆️protection of shores = ⬇️$ personal goods = ⬇️standard of living at home.
The trade-off between a clean environment and a high level of income:
Laws that require firms to ⬇️ pollution = ⬆️ cost of producing goods and services = ⬆️ firm costs = ⬇️ profits or ⬇️ wages or ⬆️ prices for goods and services or some combination of these three.
Another trade-off society faces is between efficiency and equity:
Efficiency refers to the size of the economic pie, and equity refers to how the pie is divided. Often, when government policies are being designed, these two goals conflict.
What is efficiency?
This is when society is getting the most it can from its scarce resources
What is equity?
This is when the benefits of those resources are distributed fairly among society’s members.
Explain the trade-off between efficiency and equity.
There are policies aimed at achieving a more equitable distribution of economic wellbeing, such as the age pension or unemployment benefits. They aim to help those members of society who are most in need.
Other policies such as the individual income tax, ask the financially successful to contribute more than others to support the government. Although these policies have the benefit of achieving greater equity, they have a cost in terms of reduced efficiency.
When the government redistributes income from the rich to the poor, it can reduce the reward for working hard. As a result, people may work less and produce fewer goods and services.
In other words, as the government tries to cut the economic pie into more equitable slices, the pie may get smaller.
Explain the following lesson from economics: The cost of something is what you give up to get it (lesson 2).
Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action. In many cases, however, the cost of some action is not as obvious as it might first appear - meaning appropriate decisions can be hard to make.
What is an example of a decision which can have unclear benefits and costs?
The decision whether to go to university.
The benefits include: intellectual enrichment and a lifetime of better job opportunities.
The costs at first glance: money spent on fees, books, rent and food. (This total does not truly represent what you give up to spend a year at university).
Problems with calculation: it includes some things that are not really costs of university education (rent and food*) and it ignores the largest cost of going to university - your time**.
- Because rent and food are costs of going to university only to the extent that they are more expensive because you are going to university (eg. Due to moving).
- When you spend a year listening to lectures, reading textbooks and writing assignments, you cannot spend that time working at a job. For most students, the wages given up to attend university are the largest single cost of their education.
What is opportunity cost?
The opportunity cost of an item is the best alternative you give up to obtain the item.
When making any decision, such as whether to attend university, decision makers should be aware of the opportunity costs that accompany each possible action.
(The net value of everything you must sacrifice - slides)
Explain the following lesson from economics: Rational people think at the margin (lesson 3).
Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can do to achieve their objectives, given the opportunities they have.
Rational people know that decisions in life are rarely black and white but usually involve shades of grey.
Give an example showing why decisions in life are rarely black and white but usually involve shades of grey.
Eg. When exams roll around, your decision is not between blowing them off and studying 24 hours a day but whether to spend an extra hour reviewing your notes instead of watching TV.
What is marginal change?
Economists use the term marginal change to describe a small incremental adjustment to an existing plan of action.
Keep in mind that margin means ‘edge’, so marginal changes are adjustments around the edges of what you are doing.
Rational people often make decisions by comparing marginal benefits and marginal cost.
What is a person’s willingness to pay for a good based on?
A person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has.
This is why people are willing to pay much more for a diamond than a cup of water.
Although water is essential the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.
When does a rational decision maker take an action?
A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.
This principle explains why people use mobile phones as much as they do, why airlines are willing to sell tickets below average cost and why people are willing to pay more for diamonds than for water.
Explain the following lesson from economics: People respond to incentives (lesson 4).
An incentive is something (such as a punishment or reward) that induces a person to act. Because rational people make decisions by comparing costs and benefits, they respond to incentives.