Principle #2: The Cost of Something Is What

Principle #1: People Face Tradeoffs. You Give Up to Get It.

To get one thing, we usually have to give up another
— Decisions require comparing costs and benefits of
thing.
alternatives.
— Leisure time v. work
— Whether to go to college or to work?
— Efficiency v. equity
— Whether to study or go out on a date?
— Whether to go to class or sleep in?

— The opportunity cost of an item is what you give up to

Making decisions requires trading obtain that item.
off one goal against another.

Principle #3: Rational People Think at the

Principle #1: People Face Tradeoffs Margin.
— Efficiency v. Equity
— Marginal changes are small, incremental adjustments to
— Efficiency means society gets the most that it can
an existing plan of action.
from its scarce resources.
— Equity means the benefits of those resources are
distributed fairly among the members of
society.
People make decisions by comparing
costs and benefits at the margin.
 Principle #6: Markets Are Usually a Good
Principle #4: People Respond to Incentives. Way to Organize Economic Activity.
— Marginal changes in costs or benefits motivate — A market economy is an economy that allocates
people to respond. resources through the decentralized decisions of
— The decision to choose one alternative over
many firms and households as they interact in
markets for goods and services.
another occurs when that alternative’s marginal
— Households decide what to buy and who to
benefits exceed its marginal costs! work for.
— Firms decide who to hire and what to produce.

Principle #5: Trade Can Make Everyone Principle #6: Markets Are Usually a Good
Better Off. Way to Organize Economic Activity.
— People gain from their ability to trade with one — Adam Smith made the observation that households
another. and firms interacting in markets act as if guided by an
— Competition results in gains from trading. “invisible hand.”
— Trade allows people to specialize in what they do — Because households and firms look at prices when
best. deciding what to buy and sell, they unknowingly
take into account the social costs of their actions.
— As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.
 Principle #7: Governments Can Sometimes
Improve Market Outcomes. Microeconomics and Macroeconomics
— Market failure occurs when the market fails to allocate — Microeconomics focuses on the individual parts of the
resources efficiently. economy.
— How households and firms make decisions and how
— When the market fails (breaks down) government can
they interact in specific markets
intervene to promote efficiency and equity. — Macroeconomics looks at the economy as a whole.
— Economy-wide phenomena, including inflation,
unemployment, and economic growth

Figure 1 The Circular Flow

Principle #7: Governments Can Sometimes
Improve Market Outcomes.
MARKETS
— Market failure may be caused by Revenue FOR
GOODS AND SERVICES
Spending

Goods •Firms sell Goods and

— an externality, which is the impact of one person or and services
sold
•Households buy services
bought

firm’s actions on the well-being of a bystander.

— market power, which is the ability of a single person FIRMS
•Produce and sell
HOUSEHOLDS
•Buy and consume
goods and services goods and services

or firm to unduly influence market prices. •Hire and use factors

of production
•Own and sell factors
of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

Copyright © 2004 South-Western

 Production Possibilities Frontier
A Refreshment of Typical Clothing • Point A is inefficient
• Points B, C and D are efficient
Microeconomic Models (units)
OF • All points in triangle ABC
completely utilize capital and
labor
B

C
A

OC
Food
(units)
15

Producer Equilibrium – Competitive

Input Markets Production Possibilities Frontier
— Cost minimization: — Marginal rate of transformation (MRT) of food for clothing is the
magnitude of the slope of the frontier
Ratio of marginal products (i.e., marginal rate of — Amount of one good that must be given up to produce one
technical substitution of labor for capital) is the additional unit of a second good
same as the input price ratio: — How much clothing must be given up to produce one additional
unit of food
— As we increase the production of food by moving along the PPF,
the MRT increases
MPL w
= = MRTS LK MC F
MPK r MRT =
MC C
14 16
 Competition and Efficiency in
Efficiency in Output Markets Output Markets • Produce at A
• Consume at B
• Inefficient at PF1/PC1
— For perfectly competitive markets, all utility maximizing • Surplus of clothing
• Shortage of food
consumers allocate their income so that their MRS Clothing
(units) PF1/PC1 •Prices will adjust: PF & PC
between two goods are equal to the ratio of prices •New equilibrium when price
PF*/PC* ratio is PF*/PC*
— Profit maximizing firms produce output to the point C1 •Therefore competitive
A equilibrium is efficient
where price is equal to MC
— MRT is equal to the MRS B
C2
C* U2
C

MC F PF
MRT = = = MRS
MC C PC U1

F1 F* F2 Food
(units)
17 19

Output Efficiency

Clothing MRS = MRT

(units)
60

PPF

Indifference Curve

Food
100
(units)
18