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Summary economics 1 for IBA
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Chapter 1. First principlesPrinciples that underlie individual choice
Economies differ worldwide. But much of the material covered in basic economies is the same
in the world, because all economics is based on a set of common principles. The first four
principles underlie individual choice:
Principle #1: Choices are necessary because resources are scarce
There are many scarce resources, including natural resources and human resources. You can't
always get what you want, you always need to give up something (e.g. time, money, health,
environment).
Principle #2: The true cost of something is its opportunity cost
The opportunity cost of something is what you must give up in order to get an item you want.
The opportunity cost of a choice is what you forgo by not choosing your next best alternative.
Free does not mean costless.
Principle #3: “How much” is a decision at the margin
The decision you make requires making a trade-off; a comparison of costs and benefits.
Decisions about whether to do a bit more or a bit less of an activity are marginal decisions. In
decisions about “how much”, the amount will be determined by the value and cost of the last
unit consumed.
Principle #4: People usually respond to incentives, exploiting opportunities to make themselves
better off
When people are offered opportunities to make themselves better off, they normally take them.
The principle that people will exploit opportunities to make themselves better off is the basis of
all predictions by economics about individual behavior.
Principles that underlie the economics of interaction
Each choice depends on choices made by other people To understand how a market economy
behaves, we have to examine this interaction in which one choice affects another. The following
5 principles underlie the economics of interaction
Principle #5: There are gains from trade
People divide tasks among themselves and each person provides a good of service that other
people want in return for different goods and services that he/she wants. Because of trade,
specialization is possible. The same principle applies to the economy as a whole.
Principle #6: Markets move toward equilibrium
,A situation is in equilibrium when no individual would be better off doing something different.
Because people respond to incentives, markets move toward equilibrium
Principle #7: Resources should be used as efficiently as possible to achieve society’s goals
Resources are used efficiently when they are used in a way that has fully exploited all
opportunities to make everyone better off. When an economy is efficient, the only way one
person can be made better off, is by making someone else worse off. In reaching full efficiency,
there often is created a conflict (e.g. equity vs efficiency in a market)
Principle #8: Markets usually lead to efficiency
Because all opportunities to make some people better off without making other people worse off
(=gains from trade), markets usually lead to efficiency. In case of market failure, individual
pursuit of self-interest makes society worse off, in which case the market becomes inefficient.
Principle #9: When markets don’t achieve efficiency, government intervention can improve
society’s welfare
When markets go wrong, an appropriately designed government policy can sometimes move
society closer to an efficient outcome by changing how society’s resources are used
Principles that underlie economy-wide interactions
Principle #10: One person’s spending is another person’s income
If some group in the economy decides to spend more, the income of other groups will rise, and
vice versa. Changes in spending have repercussions that spread through the economy.
Principle #11: Overall spending sometimes gets out of line with the economy’s productive
capacity
Overall spending sometimes doesn’t match the amount of goods and services the economy is
capable of producing: spending can fall short, or be too high (inflation)
Principle #12: Government policies can change spending
Government can spend more/less, ask more/less taxes, and can control money.
Invisible hand: self interest → good results for society as a whole
----------------------------------------------check your understanding----------------------------------------------
Chapter 2. Economic models: trade-offs and
Trade
Models in economics: Some important examples
A model is a simplified representation of reality that is used to better understand real-life
situations. The simplicity of models ensures that economics can focus one one change at a
time. Why models?
, 1. Understand complex situations
2. Analyze the effect of one change (simplicity → focus one one change)
In every model, you have to make assumptions (e.g. other things equal assumption) and
simplifications. In this chapter, 3 kinds of models are examined.
The production possibility Frontier (PPF)
The PPF illustrates the trade-offs facing an
economy that produces only two goods. It shows
the maximum quantity of one good that can be
produced for any given quantity produced of the
other. By simplifying reality, the PPF helps us
understand the following aspects of the real
economy: efficiency, opportunity cost and
economic growth.
Efficiency
As stated in chapter 1, an economy is efficient if
there are no missed opportunities. As long as the
production is on the PPF, the economy is efficient in production as there are no missed
opportunities. (To be fully efficient as economy, a lot of other factors play a part, e.g. efficient in allocation)
Opportunity cost
E.G. From A to B: To produce 8 more pizza’s, you will produce 6 less sugars. The opportunity
6
cost of one pizza is sugars (the slope of the line). Usually, we work with the simple assumption
8
that the PPF is a straight line, as with a straight line, you have constant opportunity costs.
Economists, however, think that the PPF is increasing because with a small scale, you do not
have to sacrifice resources of other goods.
Economic growth
Economic growth is the growing ability of the economy to produce goods and services, or an
expansion of the economy’s production possibilities. With economic growth, the PPF moves to
the right. Economic growth is caused by increased factors of production (land, labor, physical
capital and human capital) or progress in technology.
Comparative advantage and gains from trade
A country or company can choose to trade with another country or company and gain by
producing different things. To determine which country should produce what, you need to look
at the opportunity costs to make a good. The one with the least opportunity costs will specialize
in making that specific product; that country has a comparative advantage in producing that
product. A country has an absolute advantage when a country can make more of a good in
total compared to the other country. But comparative advantage is the basis of mutual gain. 2
countries are willing to trade only if the ‘price’ of the good each country obtains in the trade is
less than its own opportunity costs of producing the good domestically.
, Should international exchange be celebrated or is it cause for concern? On one hand, people
demand protection from foreign competition. On the other hand, trade follows comparative
advantage.
Transactions: the circular-flow diagram
In the previous models, we assume the only trades are
in the form of barter: when people directly exchange
goods or services that they have for goods or services
that they want. Simple barter, however, is rare. Which
is why, you can learn a lot about the economy by
considering the circular-flow diagram. In this diagram,
transactions that take place in an economy is shown by
2 kinds of flows: physical things and flows of money.
The simplest circular-flow diagram only contains 2
kinds of inhabitants: households and firms. Factor
markets are where firms buy resources they need to
produce goods and services (E.G. labor market). Factor
markets eventually determine an economy’s income distribution. The circular-flow diagram
ignores some complications (E.G. family-run businesses, sales from firms can be from other
firms, the government is not included)
Positive versus normative economics
Positive economics is the branch of economic analysis that describes the way the economics
actually works (a forecast). Normative economics makes prescriptions about the way the
economy should work (what if-question), no answer to whether its good or bad.
When and why economists disagree
There are two main reasons why economists disagree. Firstly, because of a difference in
values. Secondly, because they can disagree about which simplifications to make in a model.
Chapter 3. Supply and demand
Supply and demand: A model of a competitive market (volkomen concurrentie)
A competitive market is a market in which there are many buyers and sellers of the same good
or service, none of whom can influence the price at which the good or service is sold. Its
behavior is well-described by the supply and demand model, which has five key elements;
1. The demand curve
2. The supply curve
3. The set of factors that cause the demand curve to shift and the set of factors that cause
the supply curve to shift
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