Chapter 1

The Scope and Method of

Economics...pps

Case, K and Fair, R. Principles of Economics

 The Study of Economics

Economics is the study of

how individuals and societies
choose to use the scarce
resources that nature and
previous generations have
provided.
The Economic Problem

Unlimited Wants

Scarce Resources
Land, Labour,
Capital

Resource Use

Choices
 Economics is NOT about what to think, but
HOW to think!

"Economics is not a body of concrete truth, but

an engine for the discovery of the truth."

WAY of thinking in a very systematic, rational,

logical manner.
 Economic way of thinking is a powerful tool that can help
you understand a broad range of real world events."

What is Economics about? About how people make

choices.

First principle of economics is that we live in a world of

scarcity.

Second principle is that we have unlimited wants and

desires.

Third principle - given 1 and 2, we have to make choices.

Three categories of resources:

Natural materials - forests, land, minerals, rivers,

oceans, wildlife, oil, etc.

Human resources (capital) - knowledge and skills,

innovation, ingenuity, etc.
Education is developing human capital. Investing in
human capital.

Physical capital - machinery, technology, tools,

computers, equipment, etc.
Man-made resources.
 Why Study Economics?

Probably the most important reason

for studying economics is to learn
a way of thinking.

Three fundamental concepts:

Opportunity cost

Marginalism, and

Efficient markets
 Eight Guideposts to Econ Thinking

1. The use of scarce resources to produce a good is

always costly.

No such thing as a free lunch. Costs may be hidden, or

non-monetary, or delayed, but there is always a cost.
Econ use opportunity cost as a broad concept of cost,
that involves both monetary and non-monetary, implicit
and explicit cost. Opportunity cost: the next highest
valued alternative that must be sacrificed as a result of
choosing an alternative option.
 Opportunity Cost

Opportunity cost is the best

alternative that we forgo, or give
up, when we make a choice or a
decision.

Opportunity costs arise because

time and resources are scarce.
Nearly all decisions involve trade-
offs.
 2. Decision makers choose purposefully; therefore
they will economize.

Assumption of rational behavior. We assume people try

to maximize their benefits and minimize their cost,
Maximize Net Benefits. Firms maximize profits,
Individuals maximize UTILITY: general satisfaction,
happiness, general well being, etc.
 3. Incentives matter - choice is influenced in a predictable
way by changes in economic incentives.

Tax (penalize) something, you get less of it.

Subsidize (reward) something, you get more of it.

4. Economic thinking is marginal (additional) thinking.

Choice always involves changes in the status quo, and these

choices result in marginal decisions. A little more or a little
less.

The marginal cost of producing one more unit.

The marginal cost of one more passenger on a plane.
The marginal benefit/cost of taking one more/less class.
 Marginalism

In weighing the costs and benefits of a decision,

it is important to weigh only the costs and
benefits that arise from the decision.

For example, when deciding whether to produce

additional output, a firm considers only the
additional (or marginal cost), not the sunk cost.
Sunk costs are costs that cannot be avoided,
regardless of what is done in the future, because
they have already been incurred.
5. Information is costly, but helps us make better choices.
We take into account the cost of information when making
decisions.

Example:

You are going to buy a new car. You want the best car at the best
price. There is a cost of search and a benefit of search, and you
want to max benefits and min costs. One cost of search is your
time (opp cost). You get Consumer Reports, test drive different
cars, talk to your friends, etc. Then you pick a car and try to find
the best price.

Information is NOT free.

6. Economic actions generate secondary effects in addition to
immediate effects.

We have to be aware of the long-run effects as well as the short-run

effects.

Example - tariffs on sugar.

Immediate effect- increase employment/income in the domestic sugar

industry.

Secondary effect : raise the price of sugar for all consumers, which
means that they have less money to spend on other products.
Employment/income declines in the non-sugar industries.
Employment/income declines in foreign sugar-producing countries,
they have less income to purchase exports.
7. Value of a good is subjective/personal.

Preferences differ between individuals.

8. Test of a theory is its ability to predict.

Econ thinking = scientific thinking. Does an econ theory have predictive

power? Can it explain the way the real world operates?

Scientific thinking involves:

1. Developing a theory, with certain assumptions

2. Testing the theory empirically, using econometrics for example.

Problem: economists can't perform controlled experiments very easily.

Theories have to be consistent with the real world to have value.
 Efficient Markets

An efficient market is one in which

profit opportunities are eliminated
almost instantaneously.

There is no free lunch! Profit

opportunities are rare because, at
any one time, there are many
people searching for them.
 More Reasons to Study Economics

Economics involves the study of societal and

global affairs concerning resource allocation.

Economics is helpful to us as voters. Voting

decisions require a basic understanding of
economics.

Money and financial systems are an important

component of the economic system, but are not
the most fundamental issue in economics.
 The Scope of Economics

Microeconomics is the branch of economics

that examines the functioning of individual
industries and the behavior of individual
decision-making unitsthat is, business firms
and households.

Macroeconomics is the branch of economics

that examines the economic behavior of
aggregates income, output, employment, and
so onon a national scale.
 The Diverse Fields of Economics..ppt

Examples of microeconomic and macroeconomic concerns

Production Prices Income Employment
Microeconomics Production/Output Price of Individual Distribution of Employment by
in Individual Goods and Services Income and Wealth Individual
Industries and Businesses &
Businesses Price of medical Wages in the auto Industries
care industry Jobs in the steel
How much steel Price of gasoline Minimum wages industry
How many offices Food prices Executive salaries Number of
How many cars Apartment rents Poverty employees in a
firm

Macroeconomics National Aggregate Price National Income Employment and

Production/Output Level Total wages and Unemployment in
salaries the Economy
Total Industrial Consumer prices
Output Producer Prices Total corporate Total number of
Gross Domestic Rate of Inflation profits jobs
Product Unemployment
Growth of Output rate
 The Method of Economics

Normative economics, also called policy

economics, analyzes outcomes of economic
behavior, evaluates them as good or bad, and
may prescribe courses of action.

Positive economics studies economic

behavior without making judgments. It
describes what exists and how it works.
 Positive and Normative Economics

Health care can be improved Positive Statements:

with more tax funding
Capable of being verified
Pollution control is effective or refuted by resorting to
through a system of fines fact or further investigation

Society ought to provide

Normative Statements:
homes for all Contains a value
judgement which cannot
Any strategy aimed at
be verified by resort to
reducing factory closures in investigation or research
deprived areas would be
helpful
 The Method of Economics

Positive economics includes:

Descriptive economics, which involves the
compilation of data that describe phenomena and
facts.
Economic theory that involves building models of
behavior. A theory is a statement or set of related
statements about cause and effect, action and
reaction.
Empirical economics refers to the collection
and use of data to test economic theories.
 Theories and Models

A theory is a general statement of cause and

effect, action and reaction. Theories involve
models, and models involve variables.

A model is a formal statement of a theory.

Models are descriptions of the relationship
between two or more variables.

Ockhams razor is the principle that irrelevant

detail should be cut away. Models are
simplifications, not complications, of reality.
 Theories and Models

A variable is a measure that can change from

observation to observation.

Using the ceteris paribus, or all else equal,

assumption, economists study the relationship
between two variables while the values of other
variables are held unchanged.

The ceteris paribus device is part of the process

of abstraction used to focus only on key
relationships.
 Theories and Models

In formulating theories and models we must

avoid two pitfalls:
The Post Hoc Fallacy: It is erroneous to believe that
if event A happened before event B, then A caused B.
The Fallacy of Composition: It is erroneous to
believe that what is true for a part is also true for the
whole. Theories that seem to work well when applied
to individuals often break down when they are applied
to the whole.
 Economic Policy

Criteria for judging economic outcomes:

Efficiency, or allocative efficiency. An efficient

economy is one that produces what people want
at the least possible cost.

Equity, or fairness of economic outcomes.

Growth, or an increase in the total output of an

economy.

Stability, or the condition in which output is steady

or growing, with low inflation and full employment
of resources.
How to Read and Understand Graphs

Each point on the Cartesian

plane is a combination of
(X,Y) values.

The relationship between X

and Y is causal. For a given
value of X, there is a
corresponding value of Y, or
X causes Y.
Reading Between the Lines

A line is a continuous string

of points, or sets of (X,Y)
values on the Cartesian
plane.
The relationship between X
and Y on this graph is
negative. An increase in the
value of X leads to a
decrease in the value of Y,
and vice versa.
 Positive and Negative Relationships

An upward-sloping line
describes a positive
relationship between X
and Y.

A downward-sloping
line describes a
negative relationship
between X and Y.
 The Components of a Line
The algebraic expression of
this line is as follows:
Y = a + bX
where:
Y = dependent variable
X = independent variable
a = Y-intercept, or value of
Y when X = 0.
+ = positive relationship
Y Y1 Y0 between X and Y
b =
X X 1 X 0 b = slope of the line, or the
rate of change in Y
given a change in X.
 Different Slope Values

5 7
b 0 .5 b 0 .7
10 10

0 10
b 0 b
10 0
Strength of the Relationship Between
X and Y

This line is relatively flat.

Changes in the value of X have
only a small influence on the
value of Y.

This line is relatively steep.

Changes in the value of X have a
greater influence on the value of
Y.
The Difference Between a Line and a Curve

Equal increments in Equal increments in

X lead to constant X lead to diminished
increases in Y. increases in Y.
 Interpreting the Slope of a Curve

Graph A has Graph B has

a positive and a negative
decreasing slope, then a
slope. positive slope.

Graph C shows Graph D

a negative and shows a
increasing negative and
relationship decreasing
between X and slope.
Y.