Economic Theory, 3rd StagePrepared by Nyaz Najmadin

To Accompany Principles of Macroeconomics, fifth edition, 2009Principles of Macroeconomics, fifth edition, 2009

By N. Gregory Makiw

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HOW PEOPLE MAKE DECISIONS

Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we begin our study of economics with four principles of individual decision making.

Chapter 1 The principles of economics

PRINCIPLE 1: PEOPLE FACE TRADE-OFFS

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We can't do it all, so we have to cut back in some areas to focus on others.

What do economists mean by Trade-offs? And explain the case of (guns and butter).

To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another.

When people are grouped into societies, they face different kinds of trade-offs. The classic trade-off is between “guns and butter.” The more a society spends on national defense (guns) to protect its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard of living at home.

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What do economists mean by Trade-offs? Explain the case of ( a clean environment and a high level of income)

Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of the higher costs, these firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution regulations yield the benefit of a cleaner environment and the improved health that comes with it, they have the cost of reducing the incomes of the firms’ owners, workers, and customers.

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PRINCIPLE 2: THE COST OF SOMETHINGIS WHAT YOU GIVE UP TO GET IT

The opportunity cost of an item is what you give up to get that item.

Consider the decision to go to college. The main benefits are intellectual enrichment and a lifetime of better job opportunities. But what are the costs?

For most students, the earnings given up to attend school are the largest single cost of their education.

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PRINCIPLE 3: RATIONAL PEOPLE THINK AT THE MARGIN

Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action.

Rational people often make decisions by comparing marginal benefits and marginal costs. A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.

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 PRINCIPLE 4: PEOPLE RESPOND TO INCENTIVES

Because rational people make decisions by comparing costs and benefits, they respond to incentives. One economist went so far as to suggest that the entire field could be simply summarized: “People respond to incentives. The rest is commentary.”

When analyzing any policy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior.

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Incentives are crucial to analyzing how markets work. For example, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more.

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Key words

- Opportunity cost

- Marginal benefit

- Marginal cost

- Incentives

- Standard of living

- Environment

- Pollution

- Regulation

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Chapter 2: CONTROLS ON PRICES

When the price is not allowed to rise above the equilibrium point (level), the legislated maximum is called a price ceiling.

By contrast, when the price cannot fall below the equilibrium level, the legislated minimum is called a price floor.

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What will happen when the government imposes a binding price ceiling on a competitive market?

1- Rent control depresses rents below the equilibrium level. Thus, a shortage of the good arises (e.g. ice cream), the quantity of demanded exceeds the quantity supplied.

2- Long lines. Sellers must ration the scarce goods among the large number of potential buyers. Long lines are inefficient because they waste buyers’ time.

The two outcomes?

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One common example of a price ceiling is rent control. The goal of this policy is to help the poor by making housing more affordable.

Case Study: Rent Control in the Short run and the long run

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The short-run impacts of rent control

Explain why are the short-run supply and demand for housing relatively inelastic?

The reason is landlords have a fixed number of apartments to rent, and they cannot adjust this number quickly as market conditions change.

In addition, the number of people searching for housing in a city may not be highly responsive to rents in the short run because people take time to adjust their housing arrangements.

The long-run effect of rent control

Explain why are the long-run supply and demand for housing relatively inelastic?

Time is an important variable. Over time, landlords respond to low rents by not building new apartments and by failing to maintain existing ones.

On the demand side, low rents encourage people to find their own apartments (rather than living with their parents or sharing apartments with roommates) and induce more people to move into a city.

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What is “price floor”? Price floor is an attempt by the government to maintain

prices at other than (or above) equilibrium levels. Whereas a price ceiling places a legal maximum on prices, a price floor places a legal minimum.

Impacts (Effects) of price floor

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1- At this floor, the quantity of the good (e.g. ice cream) supplied exceeds the quantity demanded. Some people who want to sell ice cream at the going price are unable to. Thus, price floor causes a surplus.

2- In the case of a price floor, some sellers are unable to sell all they want at the market price. The sellers who appeal to the personal biases of the buyers, perhaps due to racial or familial ties, are better able to sell their goods than those who do not.

What are the impacts of Price Floor?

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 EVALUATING PRICE CONTROLS

Indeed, price controls are often aimed at helping the poor. For instance, rent-control laws try to make housing affordable for everyone.

Yet price controls often hurt those they are trying to help. Rent control may keep rents low, but it also discourages landlords from maintaining their buildings and makes housing hard to find.

Other ways can be accomplished. For instance, the government can make housing more affordable by paying a fraction of the rent for poor families. Unlike rent control, such rent subsidies do not reduce the quantity of housing supplied and, therefore, do not lead to housing shortages.

Key words Price ceiling Price floor Landlords Tenants Sellers Buyers Apartments Rents Inefficient equilibrium level

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