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Summary ECO_Chapter 1 Study Guide
Chapter 1 study guide includes the ten principles of economics with various test prep questions and answers. It also contains terms and definitions from chapter 1.
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1-1aChapter ReviewIntroduction Households and society face decisions about
how to allocate scarce resources. Resources are scarce in that
we have fewer resources than we wish. Economics is the study
of how society manages its scarce resources. Economists study
how people make decisions about buying and selling, and saving
and investing. We study how people interact with one another
in markets where prices are determined and quantities are
exchanged. We also study the economy as a whole when we
concern ourselves with total income, unemployment, and
inflation.
This chapter addresses ten principles of economics. The text
will refer to these principles throughout. The ten principles are
grouped into three categories: how people make decisions, how
people interact, and how the economy works as a whole.
How People Make Decisions
Principle 1: People face
trade-offs Economists often say,
“There ain’t no such thing as a free
lunch.” This means that there are always
trade-offs—to get more of something we
like, we have to give up something else
that we like. For example, if you spend
money on dinner and a movie, you won’t
be able to spend it on new clothes.
Socially, we face trade-offs as a group.
For example, there is the classic tradeoff
between “guns and butter.” That is, if
society spends more on national defense
(guns), then it will have less to spend on
social programs (butter). There is also a
social trade-off between efficiency
(getting the most from our scarce
resources) and equality (benefits being
distributed uniformly across society).
Policies such as taxes and welfare make
incomes more equal, but these policies
reduce returns to hard work, and thus,
, the economy doesn’t produce as much.
As a result, when the government tries to
cut the pie into more equal pieces, the
pie gets smaller.
Principle 2: The cost of
something is what you give
up to get it The opportunity cost of
an item is what you give up to get that
item. It is the true cost of the item. The
opportunity cost of going to college
obviously includes your tuition payment.
It also includes the value of your time
that you could have spent working,
valued at your potential earnings. It
would exclude your room and board
payment because you have to eat and
sleep whether you are in school or not.
Principle 3: Rational people
think at the margin Rational
people systematically do the best they
can to achieve their objectives. A
marginal change is an incremental
change to an existing plan. Rational
decision makers only proceed with an
action if the marginal benefit exceeds the
marginal cost. For example, you should
only attend school for another year if the
benefits from that year of schooling
exceed the cost of attending that year. A
farmer should produce another bushel of
corn only if the benefit (price received)
exceeds the cost of producing it.
Principle 4: People respond
to incentives An incentive is
something that induces a person to act.
Because rational people weigh marginal
costs and marginal benefits of activities,
they will respond when these costs or
benefits change. For example, when the
price of automobiles rises, buyers have
, an incentive to buy fewer cars while
automobile producers have an incentive
to hire more workers and produce more
autos. An increase in the price of
gasoline causes people to buy smaller
cars, ride mass transit, and ride bicycles.
Public policy can alter the costs or
benefits of activities. For example, a tax
on gasoline raises the price and
discourages the purchase of gasoline.
Some policies have unintended
consequences because they alter
behavior in a manner that was not
predicted.
How People Interact
Principle 5: Trade can make
everyone better off Trade is
not a contest in which one wins and one
loses. Trade can make each trader better
off. Trade allows each trader to
specialize in what he or she does best,
whether it be farming, building, or
manufacturing, and trade their output
for the output of other efficient
producers. This is as true for countries
as it is for individuals.
Principle 6: Markets are
usually a good way to
organize economic
activity In a market economy, the
decisions about what goods and services
to produce, how much to produce, and
who gets to consume them are made by
millions of firms and households. Firms
and households, guided by self-interest,
interact in the marketplace where prices
and quantities are determined. Although
this may appear to be chaos, Adam Smith
made the famous observation in
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