The Scope and Method of Economics Why Study Economics?

To learn a way of thinking To understand society To understand global affairs To be an informed citizen

3 Key Fundamental Concepts Opportunity Cost - The best alternative that we forgo, or give up, when we make a choice or a decision. o Businesses must decide on what to produce, how much to produce, where to allocate resources. - Other things you could have done in the same money and time. - Opportunity cost arises because resources are Scarce. o Scarce simply means limited. - Eg. Going to school for degree instead of working full time. Marginalism - The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. - Important to weigh only the costs and benefits that arise from the decision. o Eg. You live in Singapore and you are weighing costs and benefits of visiting your mother in Malaysia. o If business requires that you travel to Thailand, the cost of visiting your mom would be the additional, or marginal, time and money cost of getting to Malaysia from Thailand. Sunk Cost - Costs that cannot be avoided because they have already been incurred. - Eg. Already spent 1 hour waiting for queue, continue to wait because already waited for an hour. Marginalism Vs Sunk Costs - Adding additional value to change your sunk costs into something useful.

Effective Markets No Free Lunch - A market in which profit opportunities are eliminated almost instantaneously. - System that allocates resources. - The study of economics teaches us a way of thinking and helps us make decisions. To Understand Society - Another reason for studying economics is to understand society better. - Past and present economic decisions have an enormous influence on the character of life in society. - Current state, level of material well being, nature and number of jobs are all products of the economic system. - The study of economics is an essential part of the study of society.

To Understand Global Affairs - Third reason for studying economics is to understand global affairs. - An understanding of economics is essential to an understanding of global affairs. To Be an Informed Citizen - Knowledge of economics is essential to being an informed citizen. Microeconomics - The branch of economics that examines the functioning of individual industries and the behavior of individual decision making units that is, firms and households. Macroeconomics - The branch of economics that examines the economic behavior of aggregates income, employment, output and so on on a national scale. Microeconomics looks at the individual unit the household, the firm, the industry. It sees and examines the trees. Macroeconomics looks at the whole, the aggregate. It sees and analyzes the forest.

Microeconomics Vs Macroeconomics Production o Production/output in individual industries and businesses How much steel How much office space How many cars

o National production/output Total industrial output Gross domestic product Growth of output

Prices o Prices of individual goods and services Price of medical care Price of gasoline Food prices Apartment rents

o Aggregate price level Consumer prices Producer prices Rate of inflation

Income o Distribution of income and wealth Wages in the auto industry Minimum wage Executive salaries Poverty

o National Income Total wages and salaries Total corporate profits

Employment o Employment by individual businesses and industries Jobs in the steel industry Number of employees in a firm Number of accountants

o Employment and unemployment in the economy Total number of jobs Unemployment rate

The Method of Economics Positive Economics o An approach to economics that seeks to understand behavior and the operation of systems without making judgments. o It describes what exists and how it works. o (What Is) o Eg. What determines the wage rate for unskilled workers? o What would happen if we abolished the corporate income tax? o Answers to such questions are subject of positive economics. Normative Economics o An approach to economics that analyzes the outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. o Also called policy economics. o Eg. Should the government subsidize or regulate the cost of higher education? o Should medical benefits to the elderly under Medicare be available only to those with incomes below some threshold? o Should the US allow importers to sell foreign produced goods that compete with US produced products? o Should we reduce or eliminate inheritance taxes?

o Of course, most normative questions involve positive questions. o To know whether the government should take a particular action, we must know first if it can and second what the consequences are likely to be. o Eg. If we lower import fees, will there be more competition and lower prices? Descriptive Economics - The compilation of data that describe phenomena and facts. Economic Theory - A statement or a set of related statements about cause and effect, action and reaction. - Economic theory attempts to generalize data and interpret them. - Eg. Law of demand. o When the price of a product rises, people tend to buy less of it; when the price of a product falls, people tend to buy more. Model - A formal statement of a theory, usually a mathematical statement of a presumed relationship between two or more variables. Variable - A measure that can change from time to time or from observation to observation. - It has different values at different stores and at different times. - Eg. The rental price of a movie on a DVD is a variable; it has different value at different times. Ockhams Razor - The principle that irrelevant detail should be cut away. o Like maps, economic models are abstractions that strip away detail to expose only those aspects of behavior that is important to the question being asked. Although abstraction is a powerful tool for exposing and analyzing specific aspects of behavior, it is possible to oversimplify. Economic models often strip away a good deal of social and political reality to get at underlying concepts. It is just like the map example. A map made for drivers will have too many steep hills for the backpacker.

Ceteris Paribus (All Else Equal) - A device used to analyze the relationship between two variables while the values of other variables are held unchanged. - It is usually true that whatever you want to explain with a model depends on more than one factor. - Eg. If you want to explain the total number of miles driven by automobile owners in US. o The number of miles will change from year to year or month to month; it is a variable. Many things might affect the total miles driven, and we need to isolate or separate those effects. o Eg. Suppose we want to know the impact on driving of a higher tax on gasoline. This change would raise the price of gasoline at the pump but would not affect income, workplace location, number of children and so on. To isolate the impact of one single factor, we use the device of ceteris paribus, or al else equal. o Eg. We ask: what is the impact of a change in gasoline price on driving behavior, ceteris paribus, or assuming nothing else changes? So if gasoline prices rise by 10 percent, how much less driving will there be, assuming no simultaneous change in anything else- that is, assuming that income, number of children, population, laws, and so on, all remain constant? In formulating economic theory, the concept helps us simplify reality to focus on the relationships that interest us.

Implicit Cost - Hidden cost o Sydney Perth Example. o Forgo implicit cost of going to Perth if you go Sydney $400. o Implicit cost of going for education Working and earning money.

Explicit Cost - The obvious, not hidden, costs. o Cost of an item. Cautions and Pitfalls - In formulating theories and models, it is especially important to avoid two pitfalls: the post hoc fallacy and the fallacy of composition. The Post Hoc Fallacy - It can be quite tempting to look at two events that happen in sequence and assume that the first caused the second to happen. - This is not always the case. - This common error is called the post hoc, ergo propter hoc (or after this, therefore because of this) fallacy. - Eg. The Los Angeles Lakers have won seven games in a row. o Last night you went to the game and they lost. o You must have jinxed them. o They lost because you went to the game. Very closely related to the post hoc fallacy is the often erroneous link between correlation and causation. Two variables are said to be correlated if one variable changes when the other variable changes. o Eg. Lung cancer and number of cigarette lighters sold. 2 problems of this Does not show causation Omitted variable (there can be many causes)

However, correlation does not imply causation. o Eg. Cities that have high crime rates also have many automobiles, so there is a very high degree of correlation between number of cars and crime rates. o Can we argue then, that cars cause crimes? No. o Causation is when X happens, Y happens.

Association and Correlation - One does not necessary cause the other. o Eg. Crime rate and number of policeman example.

The Fallacy of Composition - The erroneous belief that what is true for a part is necessarily true for a whole o Eg. Farmers assume that farming more land will make more profits, because it works for a large piece of land. o But they forget that their land is too small, and harvesting to much will result in barren land. - Theories that seem to work well when applied to individuals or households often break down when they are applied to the whole.

Empirical Economics - The collection and use of data to test economic theories. o Eg. Economists studying the national economy collect information from government and private agencies and compile them to publish on the internet. Economic Policy - 4 criteria are frequently applied in judging economic outcomes o Efficiency o Equity o Growth o Stability Efficiency - In economics, allocative efficiency. - An efficient economy is one that produces what people want at the least possible cost. o Eg. If all members of a particular society were vegetarians and somehow half of all that societys resources were used to produce meat, the result would be inefficient. Equity - Fairness Economic Growth - An increase in the total output of an economy.

If output grows faster than the population, output per capita rises and standards of living increases.

Stability - A condition in which national output is growing steadily, with low inflation and full employment and resources. - The causes of instability and the ways in which government laws have attempted to stabilize the economy are the subject matter of macroeconomics.