No definitions on tests, how you will use the definition to answer

questions on a test. You need to know definitions.

Introduction
 Economics - The social science that studies the production, distribution and
consumption of goods and services.

 Microeconomics - The study of how individuals make decisions and how these decisions
interact.

 Macroeconomics - The branch of economics that is concerned with overall ups and
downs in the economy

 Market Economy - An economy in which production and consumption are the results of
decentralized decisions by many firms and individuals. There is no central authority
telling people what to produce or where to ship it. Each individual producer makes what
he or she thinks will be the most profitable; each consumer buys what he or she
chooses.

 Command Economy - An economy in which there is a central authority making decisions

about production and consumption. Don’t work well.
o Market economy vs Command economy - Market economies are able to
coordinate highly complex activities and to reliably provide consumers with the
goods and services they want.

 Invisible Hand - This refers to the way a market economy manages to harness the power
of self-interest for the good of society.

 Market Failure - The individual pursuit of one’s own interest, instead of promoting the
interests of society as a whole, can actually make society worse off.
o Examples: Air and water pollution as well as overexploitation of natural resources
such as fish and forests.

 Recession - A downturn in the economy.

o During a severe recession, millions of workers may be laid off.

 Economic Growth - The growing ability of the economy to produce goods and services.

Chapter 1
 Principles that underlie individual choice: The core of economics:
o Choices are necessary because resources are scarce
o The true cost of something is its opportunity cost
o “How Much” is a decision at the margin
o People usually respond to incentives, exploiting opportunities to make
themselves better off
 Opportunity Cost - The opportunity cost of an item is what you must give up in order to
get it, is its true cost.

1. Opportunity Cost = Explicit Costs + Implicit Costs

 Trade-off - You make a trade-off when you compare the costs with the benefits of doing
something.

 Marginal Decisions - Decisions about whether to do a bit more or a bit less of an activity
are marginal decisions. The study of such decisions is known as marginal analysis.

 Incentive - An incentive is anything that offers rewards to people who change their
behaviour.

 Interaction: How economies work

o There are gains from trade
o Markets move toward equilibrium
o Resources should be used efficiently to achieve society’s goals
o Markets usually lead to efficiency
o When markets don’t achieve efficiency, government intervention can improve
society’s welfare
 Trade - In a market economy, individuals engage in trade: they provide goods and
services to others and receive goods and services in return

 Gains from trade - There are gains from trade: people can get more of what they want
through trade than they could if they tried to be self-sufficient. This increase in output is
due to specialization: each person specializes in the task that he or she is good at
performing.

 Equilibrium - An economic situation is in equilibrium when no individual would be better

off doing something different.

 Efficient Economy - An economy is efficient if it takes all opportunities to make some

people better of without making the other people worse off.

 Equity - It means that everyone gets his or her fair share. Since people can disagree
about what’s fair, equity isn’t as well defined as a concept as efficiency.

 Economy-Wide Interactions
o One person’s spending is another person’s income
o Overall spending sometimes gets out of line with the economy’s productive
capacity
o Government policies can change spending

 Because people in a market economy earn income by selling things, including their own
labour, one person’s spending is another person’s income. As a result, changes in
spending behaviour can spread throughout the economy.
  Overall spending in the economy can get out of line with the economy’s productive
capacity. Spending below the economy’s productive capacity leads to a recession;
spending in excess of the economy’s productive capacity leads to inflation.

 Governments have the ability to strongly affect overall spending, an ability they use in an
effort to steer the economy between recession and inflation.

Chapter 9
Costs, Benefits and Profits
Explicit Cost - A cost that requires an outlay of money.
Example: The explicit cost of the additional year of schooling includes tuition

Implicit Cost - It is measured by the value, in dollar terms, of the benefits that are forgone
Example: The implicit cost of the year spent in school includes the income you
would have earned if you had taken a job instead.

Accounting Profit - This is equal to revenue minus explicit cost.

Economic Profit - This is equal to revenue minus the opportunity cost of resources used. It is
usually less than the accounting profit.

2. Total Revenues - (Explicit Costs + Implicit Costs) = Economic Profit.

3. Accounting Profit - Implicit Costs = Economic Profit.

Capital - The total value of assets owned by an individual or firm, Physical assets plus financial
assets.
Implicit cost of Capital - The implicit cost of capital is the opportunity cost of the use of one’s
own capital - The income earned if the capital had been employed in its next best alternative
use.

Either-Or - When faced with an “either-or” choice between 2 activities, choose the one with the
positive economic profit.

Marginal analysis
Marginal cost - The marginal cost of producing a good or service is the additional cost incurred
by producing one more unit of that good or service.

You have N − 1 units and are considering buying an extra unit which will get you to N
units

MC(N) = Cost(N units) − Cost(N − 1 units)

MC: Increase in costs when purchasing the extra unit.

Marginal Cost Curve - The marginal cost curve shows how the cost of producing one more unit
depends on the quantity that has already been produced.

Increasing Marginal Cost - Production of a good or service has increasing marginal cost when
each additional unit costs more to produce than the previous one.

Constant Marginal Cost - Production of a good or service has constant marginal cost when each
additional unit costs the same to produce as the previous one.

Decreasing Marginal Cost - Production of a good or service has decreasing marginal cost when
each additional unit costs less to produce than the previous one.

Marginal benefit - The marginal benefit of a good or service is the additional benefit derived from
producing one more unit of that good or service.

Use Benefit accounting for implicit cost i.e. use WTP as a benefit.

MB(N) = Benefit(N) − Benefit(N − 1) = WTP(N) − WTP(N − 1)

MB: Increase in benefits when purchase the extra unit i.e. Marginal Willingness to Pay
(MWTP)

Decreasing Marginal benefit - There is a decreasing marginal benefit from an activity when each
additional unit of the activity yields less benefit than the previous unit.

Marginal benefit curve - The marginal benefit curve shows how the benefit from producing one
more unit depends on the quantity that has already been produced.

Optimal quantity - The quantity that generates the highest possible total profit.
Profit-maximizing principle of a marginal analysis - According to the profit-maximizing principle
of marginal analysis, when faced with a profit-maximizing “how much” decision, the optimal
quantity is the largest quantity at which the marginal benefit is greater than or equal to marginal
cost.

Sunk Costs - A sunk cost is a cost that has already been incurred and is nonrecoverable. A
sunk cost should be ignored in decisions about future actions because they have no influence
on their actual costs and benefits.

Behavioural Economics
Rational Decisions - A rational decision-maker chooses the available option that leads to the
outcome he or she most prefers.

3 Reasons why people might prefer a worse economic payoff:

 Concerns about Fairness: (Example) There is no law that requires you to tip a waiter.
But because of concern for fairness leads most people to leave a tip because a tip is
seen as fair compensation for good service according to society’s norms.
 (Example) Another example of this could be gift-giving. If you care about another
person’s welfare, it’s rational for you to lower your own economic payoff in order
to give that person a gift.

 Bounded Rationality: A decision-maker operating with bounded rationality makes a

choice that is close to but not exactly the one that leads to the best possible economic
outcome.
 (Example) Retailers are particularly good at exploiting their customers’ tendency
to engage bounded rationality. Pricing items in units ending in 99 cents, takes
advantage of shoppers’ tendency to interpret an item that costs, say $2.99 as
significantly cheaper than one that costs $3.00.
 Bounded rationality leads consumers to give more weight to the $2 part of
the price (the first number they see) than the 99 cents part.

 Risk Aversion: The willingness to sacrifice some economic payoff in order to avoid a
potential loss.
 You may forgo a choice because you find that things could turn out badly.

Irrationality: An economists View

Irrational - An irrational decision-maker chooses an option that leaves him or her worse off than
choosing another available option.

The 6 Common Mistakes in Economic Decision Making:

 Misperceptions of Opportunity Costs: Someone takes an opportunity cost into account

when none actually exists

 Overconfidence: We tend to think we know more than we actually do. It can cause
trouble by having a strong adverse effect on people’s financial health. Overconfidence
often persuades people that they are in better financial shape than they actually are.
  Unrealistic Expectations about future Behaviour: Another form of overconfidence is
being overly optimistic about your future behaviour.
 (Example) By providing a way for someone to commit today to an action
tomorrow, such plans counteract the habit of pushing difficult action off into the
future such as automatic payroll deduction, savings plans, diet plans with
prepackaged foods and mandatory attendance at study groups

 Counting Dollars Unequally: By spending more with a credit card, you are in effect
treating dollars in your wallet as more valuable than dollars on your credit card balance,
although, in reality, they count equally in your budget.
 Mental Accounting: The habit of mentally assigning dollars to different accounts
so that some dollars are worth more than others.

 Loss Aversion: An oversensitivity to loss, leading to an unwillingness to recognize a loss

and move on.
 (Example) Many investors are reluctant to acknowledge that they’ve lost money
on a stock and won’t make it back. Loss aversion can help explain why sunk
costs are so hard to ignore

 Status Quo Bias: The status quo bias is the tendency to avoid making a decision
altogether.
 Why do people exhibit status quo bias? Some claim it’s a form of “decision
paralysis”

Rational Models for Irrational People

 Models based on rational behaviour still provide robust predictions about how people
behave in most markets.
 (Example) The great majority of farmers will use less fertilizer when it becomes
more expensive - a result consistent with rational behaviour