Chapter 1: Ten Principles of Economics

  • By nature, resources are scarce, meaning that they are limited and not everyone can get whatever they want
  • Economics: study of how society manages its resources
    • No one person controls all of the resources; every individual has a say in how a resource is distributed
    • Economists study how people make decisions based on resources (work, purchases, savings, etc.)
    • Economists also study larger forces/trends such as unemployment, income growth, inflation, etc.

1-1: How People Make Decisions

Summary: People make decisions based on what they have to give (opportunity cost) and comparing it to what they get. Rational people try to get the best outcome possible and use marginal changes to get the most out of their resources. Rational people also consider the costs and benefits of a purchase/behaving a certain way.

Principle 1: People Face Trade-Offs

  • Most decisions require trade-offs; give something you like to get something you like
  • Types of trade-offs in society
    • “Guns and butter”: The more spent on military/defense (guns), the less spent on quality of life goods (butter)
      • Relates to trade-off between clean environment and high income; costs more for a factory to produce goods cleanly, so they might have to provide lower wages, charge higher prices, etc.
    • Efficiency and equality: getting the most out of a society’s resources vs. giving out products equally amongst members of the society (respectively)
      • “Efficiency refers to the size of the economic pie, and equality refers to how the pie is divided into individual slices”
      • Efficiency and equality conflict with each other; giving poor people money (equality+) means that people may not work as hard and production goes down (efficiency-)
    • Trade-offs are key to understanding economics, as people try to make trade-offs most beneficial to them

Principle 2: The Cost of Something Is What You Give Up to Get It

  • Opportunity cost: Everything you give up to get an item, including time, health, money, etc.
    • Ex. Many athletes believe that spending 4 years in college has too high of an opportunity cost compared to going straight to a pro league

Principle 3: Rational People Think at the Margin

  • Economy assumes people are rational, or that they try their hardest to get the best outcome
  • Decisions are not black and white (buy a 3m$ house or be homeless?), so rational people use marginal change to slowly adjust their plans in order to get the best result
    • Marginal costs should be taken into account when making decisions
    • Ex. It’s free to watch another movie if you’ve already paid for a monthly subscription, or an airline can seat another person if they have empty seats; both marginal costs are zero
  • A classic example is “a cup of water vs. a diamond”; marginally, getting one more cup of water is much easier than getting a(nother) diamond, so water costs less
  • Rational decisions are ones where the marginal benefit (gaining one more unit) is greater than the marginal cost (how much does that extra unit cost?)

Principle 4: People Respond to Incentives

  • Incentive: Something that encourages a person to act
    • Ex. If apple prices rise, then consumers will buy fewer apples and producers will produce more apples
    • Public policymakers use incentives to affect the behaviors of citizens; taxing cigarettes causes less people to smoke
    • Incentives often affect cost-benefit calculations and must be taken into consideration

1-2: How People Interact

Summary: People trade in order to maximize their production, as trade allows for specialization. Markets facilitate trade, and governments often step in to ensure that the market runs smoothly.

Principle 5: Trade Can Make Everyone Better Off

  • Competition and trading can benefit all parties
    • Each person trades goods (work, most commonly) for other goods (food, homes, cars, etc.); competitive pricing forces goods to have low prices, benefiting consumers
    • Not participating in trade/competition means that people would have to grow their own food, build their own house, etc.
    • Trading allows for specialization and more advanced societies

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

  • Communism was founded on principle that the government should control the economy (central planning)
    • AKA Command Economy
    • Most countries that had central planning stopped using it in favor of a market economy
    • Government decides on the producers, the level of output, the consumers; pretty much everything
  • Market Economy: an economy that is based on the decisions of individual households, companies, firms, etc. to exchange goods and services; decisions are made based on whatever is the most profitable/whatever provides the best outcome
    • Can seem dangerous (no governing authority to ensure equality), but people make decisions as if guided by “an invisible hand (Adam Smith)
    • Prices are the main way the economy is controlled; determines the demand from buyers and the supply from sellers, thus displaying the value of a product to society
    • When a government interrupts the forces of natural supply and demand, the decisions of individuals don’t follow the invisible hand as much
      • Shows why communism failed: prices didn’t change to reflect the true values of products
      • Leads to excesses and shortages because the government doesn’t know how much demand there is
    • Products such as Uber show the inner workings of market economies

Principle 7: Governments Can Sometimes Improve Market Outcomes

  • Governments are necessary to enforce rules that are important to a market economy
    • These rules include property rights; individuals must be able to own and control their resources freely
  • Governments also choose whether or not to promote efficiency or equality
    • Occasionally, a market failure occurs where a free market is inefficient in its distribution of resources; government must step in to make it efficient
      • Can be caused by externality: the actions of one affects the health/well-being of another (such as pollution)
        • Can negatively or positively affect consumption and production
        • Examples include smoking cigarettes, pollution, education, or a bee farm next to an orange orchard
      • Can also be caused by market power: one (or a few) person(s) or group(s) control a resource and can unnaturally change its price due to its necessity
      • Asymmetric Information: one party has more information than another; can lie and be dishonest with a price
        • Adverse Selection: Market failure where products of lower quality are sold at the same price as those of higher quality; too many low quality products are sold
        • Moral Hazard: When a party can change their behavior without taking on risk, typically in the form of insurance
    • Free markets can cause large wealth disparities and inequalities; government can step in and provide basic goods + welfare for those at the bottom of the economic ladder
  • Public policy not always perfect; can be corrupted or abused

1-3: How the Economy as a Whole Works

Summary: Countries that are able to produce more goods and services have a higher standard of living. Printing can stimulate an economy, leading to the hiring of more workers, but it can also lead to higher inflation. Often, printing money (or the lack thereof) causes random business cycles.

Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services

  • Different countries have different qualities of life and average incomes; higher income == higher quality of life
    • This difference relies on a countries’ productivity, or the goods/services output per unit of work input
    • Countries with higher productivities generally have a higher standard of living than countries with lower productivities
      • This relationship means that other factors are far less important in determining standard of living
    • Policy makers must create policy based on increasing productivity

Principle 9: Prices Rise When the Government Prints Too Much Money

  • Inflation: A rise in prices across an economy
    • Inflation typically occurs because governments print money; more money –> money is less valuable –> prices increase

Principle 10: Society Faces a Short-Run Trade-Off between Inflation and Unemployment

  • Printing money stimulates the economy, causes companies to hire more people, and increases production BUT it causes higher prices in the long term
    • Leads to business cycles: large, irregular, and unpredictable changes in economic activity
    • Government spending, printing, and taxing can all affect inflation, productivity, and more - it’s up for debate how much (if at all) the government should do

Chapter 2: Thinking Like an Economist

2-1: The Economist as Scientist

Summary: Economists can act as a scientist in the sense that they create hypotheses in order to understand more about the field. They must make assumptions in order to form these hypotheses/conclusions. There are many models to represent an economy. There are two studies of economics: micro and macro.

The Scientific Method: Observation, Theory, and More Observation

  • Newton first observed an apple fall, created a theory about gravity, and observed to see if his theory was correct; this method can be applied to economics
    • Ex. An economist could theorize that inflation and high prices were related, then gather data from countries and see if his theory is correct
  • Difference between traditional sciences and economics is that economics cannot create controlled experiments; they must make do with real world data
    • Historical events often provide the best study cases for how a key resource affects an economy, such as wars in the Middle East

The Role of Assumptions

  • Economists must make assumptions in order to simplify complex situations and clarify them
    • Ex. Breaking down a complicated problem (analyzing international trade) into smaller parts (analyze trade between two countries and with two products) to better understand the concepts
  • The elegance of economics is deciding what assumptions to use
    • Ex. When studying effects of inflation on price, you could assume that short term prices will stay similar while long term prices will fluctuate greatly

Economic Models

  • Models often omit details to show what is really important and are built with assumptions

Our First Model: The Circular-Flow Diagram

  • Circular-flow diagram is used to show how groups in an economy interact with each other Screen Shot 2022-09-27 at 1 12 05 AM
  • In the diagram, households (consumers) and firms (producers) participate in two markets
    • Markets for goods and services are ones where households buy the products of firms
    • Markets for the factors of production are ones where households provide input (labor, money, etc.) to firms for the firms to create goods and services
  • Inner loop represents the flow of inputs (labor, land, capital) and outputs (goods and services)
  • Outer loop represents the flow of dollars/money; paying wages, buying goods, etc.
  • Circular-flow diagram is good to understand how different parts of the economy interact
  • Assumed that there is no government intervention, foreign trade

Our Second Model: The Production Possibilities Frontier

  • Most economic models are built using mathematics
  • The production possibilities frontier is a graph that displays the different levels of output for two goods (assuming that an economy only produces those two goods) Screen Shot 2022-09-27 at 1 25 29 AM
  • The outermost line represents the maximum efficiency of the economy (efficient combinations lie on this line); can only produce that many products given its resources
    • Any points outside of the border (such as point C) cannot be reached in the current state of the economy
    • Any points inside of the border but not on the line (such as point D) are deemd inefficient because they don’t use the maximum amount of resources
  • The graph relates to both trade-offs and opportunity costs
    • Trade-off between producing more/less of one product than the other
    • Opportunity cost is depends on the slope of the frontier; lower slope = lower opportunity cost, steeper slope = higher opportunity cost
  • Econoomists believe that production possibilities frontiers will generally have a curved shape
    • Ex. If all of an economy’s resources (including car makers) are being used to make computers, then making one car will barely inhibit computer production and vice verse; leads to different slopes at the ends
  • Frontiers can shift depending on economic growth or change Screen Shot 2022-09-27 at 1 38 03 AM
  • The frontier establishes scarcity, efficiency, trade-offs, opportunity cost, and growth; good model for demonstrating economics

Microeconomics and Macroeconomics

  • Microeconomics: The study of how households and firms interact with each other and make decisions on a small scale (in one market, for example)
  • Macroeconomics: The study of how things can affect an entire economy
  • Both are tied to each other; impossible to understand macroeconomic concepts without knowing microeconomic ones
    • Both fields are still very different, warranting different courses

2-2: The Economist as Policy Advisor

Summary: Economists can make either positive or normative statements. Policymakers listen to these statements and form laws based on the advice, though economists are not always listened to.

Positive versus Normative Analysis

  • A positive statement is objective and makes a statement about how the world is
  • A normative statement is subjective and makes a statement about how the world should be
  • Positive statements can be analyzed, rationed with, and (dis)proven, while normative statements must be evaluated using both facts and moral values

Economists in Washington

  • Economists must describe both options to policy makers in order for them to make a well-informed decision
  • Economists give advice, formulate plans, design tax policy, analyze data, evalutate public policy, provide new insight through research and publications, and more

Why Economists’ Advice Is Not Always Followed

  • Economic policy, in practice, cannot be enforced as it would be in theory
  • Lawmakers must appeal to the masses (as well as Congress) and change portions of suggested economic policy in order to do so

2-3: Why Economists Disagree

Summary: Economists disagree on issues because they have different values and may interpret data differently. However, there are many “controversial” issues that economists typically agree on.

Differences in Scientific Judgments

  • Economists are always trying to understand world economies, so they might disagree if they interpret certain discoveries differently
    • This includes controversial concepts like supply-side economics and welfare

Differences in Values

  • Economists may disagree on the “fairness” of policies based on their values or upbringings

Perception versus Reality

  • Economists agree on many propositions that may be more controversial to the public, such as rent control and enforcing tariffs Screen Shot 2022-09-27 at 1 54 25 AM
    • Despite the fact that economists agree, if politicans were to implement such policies (like rent control), they might not get reelected/lose popularity, thus causing contradictions between public policy and agreed upon propositions

Chapter 3: Interdependence and the Gains from Trade

3-1: A Parable for the Modern Economy

Summary: Trade can benefit both parties even if one party is absolutely better than the other at producing a certain good. Trade allows for specialization.

  • Scenario: Let’s say there are two people, Ruby and Frank, and two goods, beef and potatoes
    • Ruby can only produce beef and Frank can only produce potatoes
    • Both parties would benefit from trading with each other, as they would have more variety in their diets (beef + potatoes vs. only beef or only potatoes)
    • Can also trade other things; if Ruby can’t farm potatoes well and Frank can’t raise cattle, then they could trade farms
  • Guiding Question: What if one person is better at producing every good?

Production Possibilities

  • Assuming that Frank and Ruby could work 8 hours a day, they can only devote so much time to raising cattle or growing potatoes
  • Production possibilities frontier for both farmers: Screen Shot 2022-09-27 at 4 42 26 PM
    • These frontiers are not curved (or “bowed-out”) because each farmer’s efficiency remains the same regardless the amount of time spent on either task
  • The frontiers show us what would happen if both farmers were self sufficient and are good at displaying the trade-offs they make, but aren’t effective at showing what decisions they would make

Specialization and Trade

  • Ruby tells Frank to spend all of his time farming potatoes (which he is more efficient at)
  • Ruby spends more of her time farming cattle (which she is better at than Frank) and some of her time growing potatoes
  • By specializing and trading their specialized goods, both farmers benefit and consume more of both foods Screen Shot 2022-09-27 at 4 47 32 PM

3-2: Comparative Advantage: The Driving Force of Specialization**

Summary: Comparative advantage determines how trade is conducted; if both parties have a comparative advantage over one another, then they can export the good that they are more efficient in producing. For both parties to benefit, the price of trade should be between their opportunity costs.

Absolute Advantage

  • Absolute advantage is used to compare two firms, countries, people, etc.; one group has an absolute advantage if they use less inputs for the same output
    • Ruby takes 20 minutes to make an ounce of meat and 10 minutes to make an ounce of potatoes, while Frank takes 60 and 15 minutes, respectively; Ruby has an absolute advantage over Frank

Opportunity Cost and Comparative Advantage

  • In this scenario, opportunity cost represents the trade-off in time between producing meat and potatoes
    • Ruby can make 2 ounces of potatoes in the time it takes to make 1 ounce of meat; her opportunity cost for 1 ounce of potatoes is 1/2 ounce of meat
    • Frank can make 4 ounces of potatoes in the time it takes to make 1 ounce of meat; his opportunity cost for 1 ounce of potatoes is 1/4 ounce of meat
  • Comparative advantage: Having a lower opportunity cost to produce a good compared to another producer
    • Despite Frank being worse at producing both goods, he has a comparative advantage over Ruby because 1/4 < 1/2
    • One person cannot have a comparative advantage in both goods because the comparative advantages are inverse; if you have a low opportunity cost for one good, it’ll be higher for the other good Screen Shot 2022-09-27 at 4 59 38 PM

Comparative Advantage and Trade

  • When people specialize in producing a good that they have a comparative advantage in, the total production of the economy rises, making everyone better off
  • By trading, people can obtain goods at a lower opportunity cost and therefore get more net goods

The Price of Trade

  • To determine the price at which parties trade at, a general rule can be applied: For both parties to gain from trade, the price at which they trade must lie between their opportunity costs
    • Frank and Ruby trade at a price of 3 ounces of potatoes for 1 ounce of meat; Ruby’s opportunity cost is 2 ounces of potatoes for 1 ounce of meat and Frank’s is 4 ounces of potatoes for 1 ounce of meat
    • Any price between 2 and 4 would benefit both parties
      • If below 2, then both parties would want to buy meat because it’s cheaper than their opportunity cost; if above 4, then both parties would want to sell meat because the price is higher than their opportunity cost

3-3: Applications of Comparative Advantage

Summary: Examples of how comparative advantages apply to the real world.

Should LeBron James Mow His Own Lawn?

  • James is a great athlete, but the time he wastes on mowing his lawn could be used on other things such as recording a commercial or otherwise
    • Regular people have a comparative advantage over James, so James should hire people to mow his lawn for him (and compensate them at a price that is higher than their opportunity cost)

Should the United States Trade with Other Countries?

  • Goods bought from abroad are called imports and goods sold to other countries are exports
  • If one country is more adept at producing a certain good compared to another country, then they should export that good while importing a good that said other country has a comparative advantage in
  • Trade can benefit both parties, but it may hurt individuals; importing cars and exporting farmed goods affects autoworkers and farmers differently