Economics is the study of how society manages and allocates its scarce resources. Scarcity refers to society s limited number of resources

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1 Economics Notes 10 Lessons From Economics Chapter 1 What is Economics? Economics is the study of how society manages and allocates its scarce resources. Scarcity refers to society s limited number of resources How People Make Decisions: Lesson 1 People Face trade-offs. Ultimately there is no such thing as a free lunch. Something must always be given up in order to obtain something else. E.g. time for a free lunch. A large trade-off faced by society is that between efficiency and equity. o Efficiency means society is getting the most from its scarce resources. o Equity means the benefits of those resources are being distributed fairly to members of society. Efficiency and equity can conflict when government policies are implemented. E.g. when government redistributes money of wealthy to the poor there is less incentive to work hard. So more equity can equal less efficiency. Lesson 2 The Cost Of Something Is What You Give Up To Get It. Because people face trade-offs, decisions require comparing costs and benefits of alternatives. E.g. whether to go to university or seek employment. Opportunity Cost is what must be foregone or given up in order to obtain something wanted. E.g. money for a new pair of shoes or time for a free lunch with mum. Lesson 3 Rational People Think at The Margin. Marginal changes are small incremental adjustments to an existing plan of action. o E.g. studying for one extra hour instead of watching TV. Rational people often make decisions by comparing marginal benefits and marginal costs. o E.g. an airline that normally sells tickets for $500 will likely sell 10 empty seats for $300 just before the flight is about to take off because the marginal cost is less than having empty seats on the flight. Lesson 4 People Respond to Incentives. Marginal changes in costs or benefits motivate people to respond. o By incentivising at the margin you can change peoples decisions. The decision to choose one alternative over another occurs when the marginal benefit is greater than the marginal cost. How People Interact: Lesson 5 Trade Can Make Everyone Better Off. People gain from their ability to trade with one another. Countries cannot do everything themselves so it is beneficial to trade.

2 Trade allows people and nations to specialise in what they do best. Lesson 6 Markets are Usually a Good Way to Organise Economic Activity. A market economy allocates resources through the decentralised decisions of many firms and households as they interact in markets for goods and services. o Firms decide who to hire and what to make. Households decide who to work for and what to buy with their income. Adam Smith s Invisible Hand metaphor notes that buyers and sellers act in their own interest and their decisions are mostly guided by their own self-interest. Lesson 7 Government Can Sometimes Improve Market Outcomes. Governments intervene to prevent market failure. o Market Failure a situation where markets left to operate on their own fail to allocate resources efficiently. A cause of market failure can be externalities. o Externality is the impact of one person s actions on a bystander. Externalities can be negative (cause a detriment to the bystander) or positive (provide a benefit to the bystander). Market power is also a cause of market failure. o Market Power the ability of a single economic actor to have a substantial influence on market prices. Monopoly control makes it too difficult for competitors to compete, which is inequitable. E.g. Microsoft. Market Economies are also inequitable because they reward those with the ability to produce. The government intervenes with social welfare payments to help achieve a more equitable market economy. How the Economy as a Whole Works: Lesson 8 A Country s Standard of Living Depends on its Ability to Produce Goods and Services. A country s standard of living can be measured in many different ways. o E.g. by comparing incomes or comparing total market value of a nations production (GDP). Large differences exist between Country s living standards. o E.g. in 2007 the average Australian income was US $36,553, while the average Indian income was US $797. What drives living standards is productivity. o Productivity the quantity of goods and services produced from each hour of a workers time. Lesson 9 Prices Rise When The Government Prints Too Much Money. Inflation is an increase in the overall level of prices in the economy. A huge long-term cause of inflation is the government producing more quantities of money. As this happens the value of money decreases. Lesson 10 Society Faces a Short-Term Trade-Off Between Inflation and Unemployment. Reducing inflation is often thought to cause a temporary rise in unemployment. When unemployment is really low more people have access to money and this means they can purchase more goods, this ultimately forces prices up, and if prices rise too quickly inflation occurs.

3 The Phillips Curve Demonstrates this: Thinking Like an Economist Chapter 2 The Economist as Scientist: Economists operate similarly to scientists in that they devise theories, collect data and then analyse these data in an attempt to verify or refute their theories. What economists and scientists have in common is that they both use the scientific method. Scientific Method Observation, Theory and More Observation There is interplay between theory and observation for economists. o E.g. theory of inflation that may arise from printing too much money can be observed. In economics theories can sometimes be too difficult to test because experiments cannot be performed. The Role of Assumptions Economists make assumptions because assumptions make the world easier to understand. The art in scientific thinking is deciding which assumption to make. Economists use different assumptions to answer different questions. Assumptions give a starting point for discussion. Economic Models: Models simplify reality to improve understanding of the world. All economic models are built on assumptions. The Circular Flow Diagram Our First Model The circular-flow diagram shows how dollars flow through markets among households and firms in an economy. Firms produce goods and services using factors of production (land, labour, capital, enterprise). o Factors of Production inputs used to produce goods and services. Households own the factors of production and consume the goods and services produced by firms. Households and firms interact in both the markets for goods and services and the market for factors of production.

4 In the inner-loop (flow of goods and services) factors of production flow from households to firms and goods and services flow from firms to households. In the outer-loop (flow of money) spending on goods and services flows from households to firms and income from wages, rent and profit flow from firms to households. The Production Possibility Frontier Our Second Model The PPF is a graph showing the combinations of output that an economy can possibly produce given: o the available factors of production; and o the available production technology. Points A and C occur when the economy is operating at maximum productivity. At Point B resources are being allocated inefficiently, causing the economy to operate inefficiently. Point D is not feasible, as the economy doesn t have the resources to achieve that level of production. The PPF illustrates the following concepts: o Efficiency o People face trade-offs o Opportunity cost of producing one good as opposed to the other. o Economic growth Economic growth can occur by an outward shift in the PFF. This can result from an increase in factors of production or technological advances. 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. Focuses on how decisions change things in markets. Macroeconomics looks at the economy as a whole. Economy-wide phenomena, including inflation, unemployment, and economic growth. The Economist as Policy Advisor: The Market Forces of Supply and Demand Chapter 4 Markets and Competition: A market is a group of buyers or sellers of a particular good or service. Buyers determine demand for a good or service.

5 Sellers determine the supply of a good or service. Competitive market a market in which there are so many buyers and so many sellers that each has an insignificant impact on the market price. There is little reason for the seller to charge less than the going price, and if they decide to charge significantly more than buyers will just buy elsewhere. Similarly no single buyer can influence the price. Perfect Competition vs. Monopoly: For supply and demand we assume perfect competition. This assumes: 1. All goods and services offered are exactly the same. 2. Buyers and sellers are so numerous that no single buyer or seller has an influence on the market price. This means buyers and sellers must accept the market price that is set. They are price takers (no control over price). An example is the wheat market. Some markets however are monopoly markets. This occurs where: 1. Only one seller exists who sets the price. An example is Microsoft in the early 90s. Most markets lie somewhere between a perfectly competitive market and a monopoly. Demand: Demand a person s willingness to buy a product. Quantity Demanded the amount of a good buyers are willing and able to purchase. Law of Demand as the price of a product increases, the quantity demanded decreases. Demand Schedule table that shows the relationship between the price of a good and the quantity demanded. Demand Curve graph of the relationship between price of a good and quantity demanded. Market Demand vs. Individual Demand: Individual demand - the demand of a good for one person. Market demand the sum of all individual demands for a particular good or service. To obtain the market demand curve, individual demand is added horizontally. Movements and Shifts on the Demand Curve: