lOM oA RcPSD 266 833 4

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lOM oA RcPSD |266 833 4 Chapter 1 The Big Ideas

• Incentives matter

Incentives: rewards and penalties that motivate behaviour

People respond to incentives in predictable ways, even benevolence (welwillendheid) responds to incentives ➔Smith: It is not from the benevolence of (…) that we expect our dinner, but from their regard to their own interest

• Good institutions align self-interest with the social interest

Institution: organization founded for religious, educational, professional or

social purpose. Through well-functioning markets, individual pursue their own interest also promote social interest as if led by invisible hand.If not, improve situation by changing incentives with taxes, subsidies etc.

• Trade-offs are everywhere

Opportunity cost of a choice is the value of the opportunities lost People respond to changes in opportunity costs, apart from price There are always opportunity cost because of scarcity

• Thinking on the margin

Making choices by thinking of marginal benefits or marginal costs

• The power of trade

If people specialize in goods in which they have a low opportunity cost, they can trade in mutual advantage. You can benefit from trade too even when you’re not productive.

• The importance of wealth and economic growth

Wealth (the ability to pay for catastrophes) can lead to economic growth

• Institutions matter

Entrepreneurs, investors and savers need incentives to save and invest in physical capital, innovation and efficient organization. New ideas require incentives.

• Economic booms and busts cannot be avoided but can be moderated

When the tools of monetary and fiscal policies are used appropriately, those tools can reduce swings in unemployment and GDP

• Prices rise when government prints too much money

Inflation is increase in general level of prices

• Central banking is a hard job

There is a lag between the Fed deciding what to do and when effects of decision are known -Too much money leads to inflation -Not much money leads to cutting prices and wages 2 / 3

lOM oA RcPSD |266 833 4 Chapter 2 The power of trade and comparative advantage Trade makes people better off when preferences differ Trade increases productivity through specialization and division of knowledge Trade increases productivity through comparative advantage Specialization, productivity and division of knowledge As trade develops, so does specialization and this increases productivity.Knowledge lets people specialize in production of one good and then trade for other goods.Comparative advantage

Absolute advantage: ability to produce the same good using fewer inputs

Comparative advantage: ability to produce good with lower opportunity

cost U.S. has absolute advantage in both Mexico had comparative advantage in shirts U.S. has comparative advantage in computers

Production possibility frontier (PPF): shows all

the combinations of goods that a country can produce given its productivity and supply of inputs When each country produces according to its comparative advantage and then trades, total production and consumption increase. Both lands gain from trade even though one land is more productive at producing both goods Comparative advantage and wages Differences in wages reflect differences in productivity.Trade raises wages to highest levels allowed by a country’s productivity.Wages rise in high-labour-demand industries (Mexico shirts) and fall in low-labour- demand industries (Mexico computers).Workers will move from low-wage industries to high-wage industries until wages equalize.

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