REVIEW

Chapter 1
Summary of theories

• The fundamental lessons about individual decision making are that people face trade-offs
among alter native goals, that the cost of any action is measured in terms of forgone
opportunities, that rational people make decisions by comparing marginal costs and marginal
benefits, and that people change their behavior in response to the incentives they face.

• The fundamental lessons about interactions among people are that trade and interdependence
can be mutually beneficial, that markets are usually a good way of coordinating economic
activity among people, and that the government can potentially improve market outcomes by
remedying a market failure or by promoting greater economic equality.

• The fundamental lessons about the economy as a whole are that productivity is the ultimate
source of living standards, that growth in the quantity of money is the ultimate source of
inflation, and that society faces a short-run trade-off between inflation and unemployment.

10 principles of Economics

How People Make Decisions

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

How People Interact

5: Trade Can Make Everyone Better Off

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

7: Governments Can Sometimes Improve Market Outcomes

How the Economy as a Whole Works

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-Run Trade-off between Inflation and Unemployment

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• Economists try to address their subject with a scientist’s objectivity. Like all scientists, they
make appropriate assumptions and build simplified models to understand the world around them.
Two simple economic models are the circular-flow diagram and the production possibilities
frontier.

• The field of economics is divided into two subfields: microeconomics and macroeconomics.
Microeconomists study decision making by households and firms and the interactions among
households and firms in the marketplace. Macroeconomists study the forces and trends that
affect the economy as a whole.

• A positive statement is an assertion about how the world is. A normative statement is an
assertion about how the world ought to be. When economists make normative statements, they
are acting more as policy advisers than as scientists.

• Economists who advise policymakers sometimes offer conflicting advice either because of
differences in scientific judgments or because of differences in values. At other times,
economists are united in the advice they offer, but policymakers may choose to ignore the advice
because of the many forces and constraints imposed by the political process.

• Each person consumes goods and services produced by many other people both in the United
States and around the world. Interdependence and trade are desirable because they allow
everyone to enjoy a greater quantity and variety of goods and services.

• There are two ways to compare the ability of two people to produce a good. The person who
can produce the good with the smaller quantity of inputs is said to have an absolute advantage in
producing the good. The person who has the smaller opportunity cost of producing the good is
said to have a comparative advantage. The gains from trade are based on comparative advantage,
not absolute advantage.

• Trade makes everyone better off because it allows people to specialize in those activities in
which they have a comparative advantage.

• The principle of comparative advantage applies to countries as well as to people. Economists

use the principle of comparative advantage to advocate free trade among countries.

Definition, Laws and Formulas:

Scarcity is the limited nature of society’s resources economics the study of how society manages
its scarce resources.

Efficiency is the property of society getting the most it can from its scarce resources.

Equality is the property of distributing economic prosperity uniformly among the members of
society.

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Opportunity cost is whatever must be given up to obtain some items.

Rational people are people who systematically and purposefully do the best they can to achieve
their objectives.

Marginal change is a small incremental adjustment to a plan of action. There are marginal benefit
(MB) and marginal cost (MC).

Incentive is something that induces a person to act.

Market economy is an economy that allocates resources through the decentralized decisions of
many firms and households as they interact in markets for goods and services.

Central planning economy (command economy) is an economy that a central authority, such as a
government, makes economic decisions regarding the allocation of resources, the manufacturing
and the distribution of products and income.

Mixed economy is an economy that combines the elements of a market economy and the
elements of a planned economy.

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their own interest”, Adam Smith says. What he is saying is
that participants in the economy are motivated by self-interest and that the “invisible hand”
of the marketplace guides this self-interest into promoting general economic well-being.

Property right is the ability of an individual to own and exercise control over scarce resources.

Market failure is a situation in which a market left on its own fails to allocate resources
efficiently.

Externality is the impact of one person’s actions on the well-being of a bystander.

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

Productivity is the quantity of goods and services produced from each unit of labor input.

Inflation is an increase in the overall level of prices in the economy.

Business cycle includes fluctuations in economic activity, such as employment and production.

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Principle: short-run trade-off between unemployment and inflation:

The short-run effects of monetary injections as follows:

• Increasing the amount of money in the economy stimulates the overall level of spending and
thus the demand for goods and services.

• Higher demand may over time cause firms to raise their prices, but in the meantime, it also
encourages them to hire more workers and produce a larger quantity of goods and services.

• More hiring means lower unemployment.

Circular-flow diagram is a visual model of the economy that shows how dollars flow through
markets among households and firms

Firms produce goods and services using inputs, such as labor, land, and capital (buildings and
machines). These inputs are called the factors of production.

Figure: Circular flow of income

Production possibilities frontier is a graph that shows the combinations of output that the
economy can possibly produce given the available factors of production and the available
production technology.

PPF bows out (concave curve) due to the law of diminishing return.

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 Figure: Production possibility frontier (PPF)

A, B, E, F: efficient points

D: feasible but inefficient points

C: unattainable points

Trade-off when moving from point A to B: increase 100 cars but decrease 200 computers

When the economy grows, based on expansion of resources, PPF shifts outwards to the red
curve.

Microeconomics is the study of how households and firms make decisions and how they interact
in markets.

Macroeconomics is the study of economy wide phenomena, including inflation, unemployment,

and economic growth.

Positive statements claims that attempt to describe the world as it is. For example: Minimum-
wage laws cause unemployment.

Normative statements claims that attempt to prescribe how the world should be. For example:
The government should raise the minimum wage.

Absolute advantage is the ability to produce a good using fewer inputs than another producer.

Comparative advantage is the ability to produce a good at a lower opportunity cost than another
producer

Imports are goods produced abroad and sold domestically.

Exports are goods produced domestically and sold abroad.

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Multiple choice questions:

1. Economics is best defined as the study of

a. how society manages its scarce resources.

b. how to run a business most profitably.

c. how to predict inflation, unemployment, and stock prices.

d. how the government can stop the harm from unchecked self-interest.

2. Your opportunity cost of going to a movie is

a. the price of the ticket.

b. the price of the ticket plus the cost of any soda and popcorn you buy at the theater.

c. the total cash expenditure needed to go to the movie plus the value of your time.

d. zero, as long as you enjoy the movie and consider it a worthwhile use of time and money

3. A marginal change is one that

a. is not important for public policy

b. incrementally alters an existing plan

c. makes an outcome inefficient

d. does not influence incentives.

4. Adam Smith’s “invisible hand” refers to

a. the subtle and often hidden methods that businesses use to profit at consumers’ expense.

b. the ability of free markets to reach desirable outcomes, despite the self-interest of market
participants.

c. the ability of government regulation to benefit consumers, even if the consumers are unaware
of the regulations.

d. the way in which producers or consumers in unregulated markets impose costs on innocent
bystanders.

5. Governments may intervene in a market economy in order to

a. protect property rights.

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b. correct a market failure due to externalities.

c. achieve a more equal distribution of income.

d. All of the above.

6. If a nation has high and persistent inflation, the most likely explanation is

a. the central bank creating excessive amounts of money.

b. unions bargaining for excessively high wages.

c. the government imposing excessive levels of taxation.

d. firms using their monopoly power to enforce excessive price hikes.

7. An economic model is

a. a mechanical machine that replicates the functioning of the economy.

b. a fully detailed, realistic description of the economy.

c. a simplified representation of some aspect of the economy.

d. a computer program that predicts the future of the economy.

8. The circular-flow diagram illustrates that, in markets for the factors of production,

a. households are sellers, and firms are buyers.

b. households are buyers, and firms are sellers.

c. households and firms are both buyers.

d. households and firms are both sellers.

9. A point inside the production possibilities frontier is

a. efficient but not feasible.

b. feasible but not efficient.

c. both efficient and feasible.

d. neither efficient nor feasible.

10. An economy produces hot dogs and hamburgers. If a discovery of the remarkable health
benefits of hot dogs were to change consumers’ preferences, it would

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a. expand the production possibilities frontier.

b. contract the production possibilities frontier.

c. move the economy along the production possibilities frontier.

d. move the economy inside the production possibilities frontier.

11. All of the following topics fall within the study of microeconomics EXCEPT

a. the impact of cigarette taxes on the smoking behavior of teenagers.

b. the role of Microsoft’s market power in the pricing of software.

c. the effectiveness of antipoverty programs in reducing homelessness.

d. the influence of the government budget deficit on economic growth.

12. Which of the following is a positive, rather than a normative, statement?

a. Law X will reduce national income.

b. Law X is a good piece of legislation.

c. Congress ought to pass law X.

d. The president should veto law X.

13. In an hour, Mateo can wash 2 cars or mow 1 lawn, and Tyler can wash 3 cars or mow 1 lawn.
Who has the absolute advantage in car washing, and who has the absolute advantage in lawn
mowing?

a. Mateo in washing, Tyler in mowing.

b. Tyler in washing, Mateo in mowing.

c. Mateo in washing, neither in mowing.

d. Tyler in washing, neither in mowing.

14. Once again, in an hour, Mateo can wash 2 cars or mow 1 lawn, and Tyler can wash 3 cars or
mow 1 lawn. Who has the comparative advantage in car washing, and who has the comparative
advantage in lawn mowing?

a. Mateo in washing, Tyler in mowing.

b. Tyler in washing, Mateo in mowing.

c. Mateo in washing, neither in mowing.

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d. Tyler in washing, neither in mowing.

15. When two individuals produce efficiently and then make a mutually beneficial trade based on
comparative advantage,

a. they both obtain consumption outside their production possibilities frontier.

b. they both obtain consumption inside their production possibilities frontier.

c. one individual consumes inside her production possibilities frontier, while the other consumes
outside hers.

d. each individual consumes a point on her own production possibilities frontier.

16. Which goods will a nation typically import?

a. those goods in which the nation has an absolute advantage

b. those goods in which the nation has a comparative advantage

c. those goods in which other nations have an absolute advantage

d. those goods in which other nations have a comparative advantage

17. Suppose that in the United States, producing an aircraft takes 10,000 hours of labor and
producing a shirt takes 2 hours of labor. In China, producing an aircraft takes 40,000 hours of
labor and producing a shirt takes 4 hours of labor. What will these nations trade?

a. China will export aircraft, and the United States will export shirts.

b. China will export shirts, and the United States will export aircraft.

c. Both nations will export shirts.

d. There are no gains from trade in this situation.

18. Kayla can cook dinner in 30 minutes and wash the laundry in 20 minutes. Her roommate
takes half as long to do each task. How should the roommates allocate the work?

a. Kayla should do more of the cooking based on her comparative advantage.

b. Kayla should do more of the washing based on her comparative advantage.

c. Kayla should do more of the washing based on her absolute advantage.

d. There are no gains from trade in this situation.

Answers: 1.a 2.c 3.b 4.b 5.d 6.a 7.c 8.b 9.b 10.c 11.d
12.a 13.d 14.b 15.a 16.d 17.b 18.d

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