WEEK 1 - Chapter 1: 10 Lessons From Economics

Question 1

Where does the word ‘economy’ come from?

Answer 1

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.

Question 2

How are households and economies similar?

Answer 2

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?

Question 3

Why is the management of society’s resources important?

Answer 3

Scarcity.

Question 4

What is scarcity?

Answer 4

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.

Question 5

What is economics?

Answer 5

Economics is the study of how society manages its scarce resources.

Question 6

What do economists study?

Answer 6

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.

Question 7

How are resources allocated?

Answer 7

In most societies, resources are allocated through the combined choices of millions of households and firms.

Question 8

Although the study of economics has many facets, how is it unified?

Answer 8

It is unified by several central ideas. These central ideas are titled the 10 lessons from economics in this book.

Question 9

What does the behaviour of an economy reflect?

Answer 9

The behaviour of an economy reflects the behaviour of the individuals who make up the economy.

Question 10

What are the 10 lessons from economics?

Answer 10

1. People face trade-offs.
2. The cost of something is what you give up to get it.
3. Rational people think at the margin.
4. People respond to incentives.
5. Trade can make everyone better off.
6. Markets are usually a good way to organise economic activity.
7. Governments can sometimes improve market outcomes.
8. A country’s standard of living depends on its ability to produce goods and services.
9. Prices rise when the government prints too much money.
10. Society faces a short-term trade-off between inflation and unemployment.

Question 11

Explain the following lesson from economics: People face trade-offs (lesson 1).

Answer 11

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.

Question 12

What are some typical trade-offs?

Answer 12

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.

Question 13

What is efficiency?

Answer 13

This is when society is getting the most it can from its scarce resources

Question 14

What is equity?

Answer 14

This is when the benefits of those resources are distributed fairly among society’s members.

Question 15

Explain the trade-off between efficiency and equity.

Answer 15

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.

Question 16

Explain the following lesson from economics: The cost of something is what you give up to get it (lesson 2).

Answer 16

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.

Question 17

What is an example of a decision which can have unclear benefits and costs?

Answer 17

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.

Question 18

What is opportunity cost?

Answer 18

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)

Question 19

Explain the following lesson from economics: Rational people think at the margin (lesson 3).

Answer 19

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.

Question 20

Give an example showing why decisions in life are rarely black and white but usually involve shades of grey.

Answer 20

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.

Question 21

What is marginal change?

Answer 21

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.

Question 22

What is a person’s willingness to pay for a good based on?

Answer 22

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.

Question 23

When does a rational decision maker take an action?

Answer 23

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.

Question 24

Explain the following lesson from economics: People respond to incentives (lesson 4).

Answer 24

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.

Question 25

What are incentives crucial for?

Answer 25

Incentives are crucial to analysing how markets work.

Eg. when the price of an apple rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more workers and harvest more apples. In other words, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more.

Question 26

What should public policy makers never forget?

Answer 26

Public policymakers should never forget about incentives. Many policies change the costs or benefits that people face and, as a result, alter their behaviour.

Eg. A tax on petrol encourages people to drive smaller, more fuel-efficient cars. A petrol tax also encourages people to take public transportation rather than drive, and to live closer to where they work.

Question 27

How can policies have unintended effects when policy makers fail to consider how behaviour might change as a result?

Answer 27

Eg. Making seatbelt compulsory to wear - When wearing seat belts is compulsory, more people wear seat belts and the probability of surviving a major car accident rises. In this sense, seat belts save lives.

When deciding how safely to drive, rational people compare the marginal benefit from safer driving with the marginal cost.

They drive more slowly and carefully when the benefit of increased safety is high. This explains why people drive more slowly and carefully when roads are wet and slippery than when roads are clear.

Now consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts make accidents less costly because they reduce the probability of injury or death. In other words, wearing a seat belt reduces the benefits of slow and careful driving.

People respond to wearing seat belts as they would to an improvement in road conditions – by driving faster and less carefully. The result of a seat belt law, therefore, is a larger number of accidents.

The decline in safe driving has a clear, adverse impact on pedestrians who are more likely to find themselves in an accident but, unlike the drivers, are not protected by a seat belt. Thus, a seat belt law tends to increase the number of pedestrian deaths.

Question 28

Explain the following lesson from economics: Trade can make everyone better off (Lesson 5).

Answer 28

Trade between Australia and another country is not like a sports contest, where one side wins and the other side loses.

In fact, the opposite is true – trade between two countries can make each country better off and, hence, workers (on average) better off.

Trade allows countries to specialise in what they do best and to enjoy a greater variety of goods and services.

Question 29

Explain the following lesson from economics: Markets are usually a good way to organise economic activity (lesson 6).

Answer 29

Most countries that once had centrally planned economies have abandoned this system and are instead developing market economies.

In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households.

Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes.

These firms and households interact in the marketplace, where prices and self-interest guide their decisions.

Question 30

What is a planned economy?

Answer 30

Communist countries operated on the premise that government workers were in the best position to guide economic activity.

These workers, called central planners, decided what goods and services were produced, how much was produced and who produced and consumed these goods and services.

The theory behind central planning was that only the government could organise economic activity in a way that promoted economic wellbeing for the country as a whole.

Question 31

What is a market economy?

Answer 31

An economy that allocates resources through the decentralised decisions of many firms and households as they interact in markets for goods and services.

At first glance, the success of market economies is puzzling. In a market economy, no one is looking out for the economic wellbeing of society as a whole. Decisions are made by millions of self-interested households and firms. It might sound like chaos. Yet this is not the case. Market economies have proven remarkably successful in organising economic activity to promote overall economic wellbeing.

Economist Adam Smith explained the success of market economies in 1776 and noted that households and firms interacting in markets act as if they are guided by an ‘invisible hand’.

Question 32

What is the invisible hand?

Answer 32

The idea that buyers and sellers freely interacting in a market economy will create an outcome that allocates goods and services to those people who value them most highly and makes the best use of our scarce resources.

Question 33

Explain the following lesson from economics: Governments can sometimes improve market outcomes (lesson 7).

Answer 33

One reason we need government is that the invisible hand can work its magic only if government enforces the rules and maintains the institutions that are key to a market economy.

Most important, markets work only if property rights are enforced so individuals can own and control scarce resources. A farmer won’t grow food if he expects his crop to be stolen and an entertainment company won’t produce DVDs if too many potential customers avoid paying by making illegal copies.

We all rely on government-provided police and courts to enforce our rights over the things we produce.

Yet there is another reason we need government.

Question 34

What are some important exceptions to the rule that markets are usually a good way to organise economic activity?

Answer 34

There are two broad reasons for a government to intervene in the economy and change the allocation of resources that people would choose on their own:

to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided.

Consider first the goal of efficiency. Although the invisible hand usually leads markets to allocate resources to maximise the size of the economic pie, this is not always the case. Economists use the term market failure to refer to a situation in which the market on its own fails to allocate resources efficiently

Now consider the goal of equity. Even when the invisible hand is yielding efficient outcomes, it can nonetheless leave big differences in economic wellbeing. A market economy rewards people according to their ability to produce things that other people are willing to pay for. The world’s best soccer player earns more than the world’s best chess player simply because people are willing to pay more to see soccer than chess. The invisible hand does not ensure that everyone has sufficient food, decent clothing and adequate health care. Many public policies, such as the tax and social welfare systems, aim to achieve a more equitable distribution of economic wellbeing.

Question 35

What is market failure?

Answer 35

A situation in which a market left on its own fails to allocate resources efficiently externality.

Eg. Market power and externalities.

Question 36

What is an externality?

Answer 36

The uncompensated impact of one person’s actions on the wellbeing of a bystander.

A positive externality makes the bystander better off.
A negative externality makes the bystander worse off.

Question 37

What is market power?

Answer 37

The ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.

Question 38

Explain the following lesson from economics: country’s standard of living depends on its ability to produce goods and services (lesson 8).

Answer 38

What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living standards is attributable to differences in countries’ productivity.

In nations where workers can produce a large quantity of goods and services per hour, most people enjoy a high standard of living; in nations where workers are less productive, most people must endure a more meagre existence.

Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income.

Question 39

Productivity and public policy.

Answer 39

The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect living standards, the key question is how it will affect our ability to produce goods and services.

To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services and have access to the best available technology.

Because lower investment today means lower productivity in the future, budget deficits are generally thought to depress growth in living standards.

Question 40

What is productivity?

Answer 40

The quantity of goods and services produced from each hour of a worker’s time.

Question 41

Explain the following lesson from economics: Prices rise when the government prints too much money (lesson 9).

Answer 41

Although Australia has never experienced inflation even close to that in Germany in the 1920s, inflation has at times been an economic problem.

During the 1970s, for instance, the overall level of prices more than doubled, and political leaders lived under the catchcry ‘Fight Inflation First!’.

In contrast, in the first decade of the twenty-first century, inflation has run at about 2.5 per cent per year; at this rate it would take almost 30 years for prices to double.

Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of economic policymakers around the world.

Question 42

What is inflation?

Answer 42

An increase in the overall level of prices in the economy.

Question 43

What causes inflation?

Answer 43

While there is some disagreement among economists about inflation in the short term, the answer in the long term is clear.

In most cases of large or persistent inflation, the culprit turns out to be the same – growth in the quantity of money.

When a government creates large quantities of the nation’s money, the value of the money falls. In Germany in the early 1920s, when prices were, on average, tripling every month, the quantity of money was also tripling every month.

Question 44

Explain the following lesson from economics: Society faces a short-term trade-off between inflation and unemployment (lesson 10).

Answer 44

If long-term inflation is so easy to explain, why do policymakers sometimes have trouble ridding the economy of it?

One reason is that reducing inflation is often thought to cause a temporary rise in unemployment.

This trade-off between inflation and unemployment is called the Phillips curve, after the economist who first examined this relationship.

Question 45

What is the Phillips curve?

Answer 45

The short-term trade-off between inflation and unemployment.

The Phillips curve remains a controversial topic among economists, but most economists today accept the idea that there is a short-term trade-off between inflation and unemployment.

According to a common explanation, this trade-off arises because some prices are slow to adjust.

Question 46

Explain the relationship between inflation and unemployment.

Answer 46

Eg. the government reduces the quantity of money in the economy. In the long term, the only result of this policy change will be a fall in the overall level of prices.

However some prices are “sticky”:
When the government reduces the quantity of money =
⬇️ amount that people spend

Lower spending + together with prices that are stuck too high = ⬇️ quantity of goods and services that firms sell = ⬆️ laid off workers.

Question 47

Opportunity cost example.

Answer 47

. You won a free ticket to see an Eric Clapton Concert (has no resale value)
. Bob Dylan is performing on the same night and is your next-best alternative activity.
. Tickets to see Bob Dylan cost $40, but you would be willing to pay up to $50 to see him.
. Assume there are not other costs of seeing either performer.

Based on this information, the opportunity cost of seeing Eric Clapton is $10 - because you lose $10 benefit if you don’t see Bob Dylan.

Benefit(satisfaction) - cost = 50 - 40 = $10 (satisfaction, aka consumer surplus) gain from seeing Bob Dylan concert (this is lost/sacrificed if you go to Eric Clapton concert).

(No such thing as a free lunch)