MGEA01H3 Lecture Notes - Lecture 1: Market Failure, Opportunity Cost, Market Economy

Part 1.Choose the correct answer of the following:

1.In a market economy, economic activity is guided by

a.Self-interest and prices

b.The government.

c.Corporations.

d. Central planners.

2. Which of the following decisions must be made by all economies?

a.How much to produce? When to produce? How much does it cost?

b.What to produce? How to produce? For whom to produce?

c.What is the price? Who will produce it? Who will consume it?

d. None of the above

3.Since the resources used in the production of goods and services are limited, society must:

a.Reduce the use of those resources

b.Try to get more resources

c.Make choices about how to use resources

d.Focus on their most abundant resource

4.Which of the following observations was made famous by Adam Smith in his book The Wealth of Nations?

a.Households and firms interacting in markets are guided by an "invisible hand" that leads them to desirable market outcomes.

b.There is no such thing as a free lunch.

c.People buy more when prices are low than when prices are high.

d. No matter how much people earn, they tend to spend more than they earn.

5.If real GDP increased by 2 percent, then

a.Government spending increased by 2 percent

b.The price level has increased by 2 percent

c.Real output/production has increased by 2 percent

d. The increase might have been caused by an increase in the price level or output, but we cannot tell for sure

6. Which of the following would show an efficient economy?

a.Uses the least costly amount of resources available

b.Has a small amount of people who do not work

c.Resources are used to make the most goods and services possible

d.None of the above

7.What is the type of unemployment that occurs when people take time to find a job?

a.cyclical

b.frictional

c.Disguised

d.structural

Considered by many to be the founder of modern economics, Adam Smith published his masterpiece The Wealth of Nations in 1776. Smith wrote in support of market economies as feudalism in Europe was unravelling. Hence, many of his insights clashed with the ideas of his contemporaries whom continued to be drawn to less modern notions of markets as governed by duties owed, hierarchy, master and servant, and paternalism. In Smith’s view, markets are guided by the self-interests of market participants, not by obligations imposed, moral or otherwise, by religious authorities, aristocracy, and crown.

Consider the following quote taken from The Wealth of Nations:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Nobody but a beggar chooses to depend chiefly upon the benevolence of his fellow-citizens….Every individual…neither intends to promote the public interest, nor knows how much he is promoting it….He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part in it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

Now suppose that Jim enters the market to purchase a gallon of milk from a local dairy. Jill enters the market to contribute $100 to a charitable cause. Based on Smith’s analysis, which transaction is guided solely by self-interest? How could either transaction contribute to the public interest? Is one superior to the other in that the first transaction confers mutual economic gains to both parties while the other confers a gain to only a single party? Are two gains superior to one? Briefly discuss.

Rules: Limit your thoughts to no more than two pages total, using Microsoft Word, 12 point type in Times New Roman font. Double spaced with one inch margins throughout. Do not worry about being right or wrong, the purpose of this exercise is for you to stretch your mind and to think critically

2.1 Adam Smith is often called the father of economics. His famous book, The Wealth of Nations, talks about an invisible hand which automatically allocates goods to the persons most able to put them to good use. The invisible hand operates through the price mechanism for goods and services, so that individuals who trade on the market, while seeking only their own good, are actually efficiently allocating society's resources.

His ideas, if applied to modern capital markets, imply that these markets would efficiently allocate investment capital to the firms that would use the capital most efficiently in producing goods and services for society. But this would happen only if markets were left to operate without state intervention.

Do you think modern governments should leave capital markets unregulated? Why or why not?

2.2 Consider a business firm, organized as a proprietorship, which has $100,000 invested in assets a bank loan of $80,000 and $20,000 personal capital invested by the proprietor. If the firm becomes insolvent, who is at risk? Why?

2.3 In the following situation, moral hazard or adverse selection may be present. Indicate which you think is present, if any, and explain your choice.

a. An investor is asking for a bank loan to support a new business she wants to operate. She is unwilling to submit to a credit check.