lOMoARcPSD|2668334
, lOMoARcPSD|2668334
Chapter 1 The Big Ideas
1. 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
2. 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.
3. 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
4. Thinking on the margin
Making choices by thinking of marginal benefits or marginal costs
5. 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.
6. The importance of wealth and economic growth
Wealth (the ability to pay for catastrophes) can lead to economic growth
7. Institutions matter
Entrepreneurs, investors and savers need incentives to save and invest in
physical capital, innovation and efficient organization. New ideas require
incentives.
8. 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
9. Prices rise when government prints too much money
Inflation is increase in general level of prices
10. 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
, lOMoARcPSD|2668334
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.
, lOMoARcPSD|2668334
Chapter 1 The Big Ideas
1. 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
2. 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.
3. 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
4. Thinking on the margin
Making choices by thinking of marginal benefits or marginal costs
5. 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.
6. The importance of wealth and economic growth
Wealth (the ability to pay for catastrophes) can lead to economic growth
7. Institutions matter
Entrepreneurs, investors and savers need incentives to save and invest in
physical capital, innovation and efficient organization. New ideas require
incentives.
8. 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
9. Prices rise when government prints too much money
Inflation is increase in general level of prices
10. 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
, lOMoARcPSD|2668334
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.
