PART I INTRODUCTION TO ECONOMICS

The Scope and Method of Economics

1
CHAPTER OUTLINE
Why Study Economics? To Learn a Way of Thinking To Understand Society To Understand Global Affairs To Be an Informed Voter The Scope of Economics Microeconomics and Macroeconomics The Diverse Fields of Economics The Method of Economics Theories and Models Economic Policy An Invitation Appendix: How to Read and Understand Graphs

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The Scope And Method Of Economics economics The study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.
key words: choose and scarce Economics is a behavioral, or social, science. In large measure it is the study of how people make choices. The choices that people make, when added up, translate into societal choices.

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The purpose of this chapter and the next is to elaborate on this definition and to introduce the subject matter of economics.

Why Study Economics?

To Learn A Way Of Thinking

Three fundamental concepts: Opportunity cost Marginalism, and Efficient markets

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Why Study Economics?

To Learn A Way Of Thinking Opportunity Cost Nearly all economic decisions involve trade-offs. Opportunity cost is directly related with these trade-offs. opportunity cost The best alternative that we forgo, or give up, when we make a choice or a decision. Opportunity cost does not have to be measured in dollar terms. The value of an alternative activity is usually measured in both monetary and nonmonetary costs.
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Opportunity costs arise because resources are scarce, that is, limited.

Question

Which of the following is NOT an opportunity cost of attending college? A) the tuition you pay B) the income you could have earned if you didn't attend college C) the alternative uses of the time you spend studying D) the cost of the food that you consume while you are attending college

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Question

If you own a building and you decide to use that building to open a book store, A) there is no opportunity cost of using this building for a book store because you own it. B) there is an opportunity cost of using this building for a book store because it could have been used in other ways. C) the only cost relevant to this decision is the price you paid for the building.

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Why Study Economics?

To Learn A Way Of Thinking Marginalism and Sunk Costs marginalism The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. sunk costs Costs that cannot be avoided, regardless of what is done in the future, because they have already been incurred. Ex: music business. To produce a typical CD, music labels spend around $300,000 on recording the music and music video, marketing materials etc.
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Once the label has made the investment the $300,000 are a sunk cost. Afterwards, physically producing another copy of the CD costs say $2. So, the marginal cost of producing the 20001st copy is $2.

Question

If you can buy 9 DVDs for $126 or you could buy 10 DVDs for $130, then the marginal cost of the tenth DVD is: A) $4. B) $13. C) $14. D) $130.

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Question

If you eat at a sushi restaurant that charges $20 for its all you can eat sushi special, then the marginal cost of your 10th piece of sushi is A) zero. B) $2. C) $20. D) $200.

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Why Study Economics?

To Learn A Way Of Thinking Efficient MarketsNo Free Lunch efficient market A market in which profit opportunities are eliminated almost instantaneously. Ex: How should you react when a stockbroker calls with a hot tip on the stock market? With skepticism. Thousands of individuals each day are looking for hot tips in the market. If a particular tip about a stock is valid, there will be an immediate rush to buy the stock, which will quickly drive up its price. There are clearly times when profit opportunities exist. Someone has to be first to get the news, and some people have quicker insights than others. The study of economics teaches us a way of thinking and helps us make decisions.

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Why Study Economics?

To Understand Society Economic decisions shape the physical environment and influence the character of society. At no time has the impact of economic change on a society been more evident than during: Industrial Revolution The period in England during the late eighteenth and early nineteenth centuries in which new manufacturing technologies and improved transportation gave rise to the modern factory system and a massive movement of the population from the countryside to the cities.
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Why Study Economics?

To Understand Society It is not surprising that the discipline of economics began to shape during this period. Adam Smiths Wealth of Nations appeared in 1776. It was followed by the writings of David Ricardo, Karl Marx, Thomas Malthus, and many others.

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The study of economics is an essential part of the study of society.

Why Study Economics?

To Understand Global Affairs Some claim that economic considerations dominate international relations. An understanding of economics is essential to an understanding of global affairs.

iPod and theValue. Ask An iPod Has Global World

the (Many) Countries That Make It. The New York Times
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An iPod contains 451 parts. Final assembly is performed by several companies in southeast Asia. Toshiba made the most expensive component, the hard drive, at a cost of $73 per unit. But the largest fraction of the iPods price is the $163 in value added paid to Apple, various U.S. distributors, and domestic component makers. The true value of the iPod is its design and conception, not the parts that go into it.

Why Study Economics?

To Be An Informed Citizen A knowledge of economics is essential to be an informed citizen. Examples: ?? When we participate in the political process, we are voting on issues that require a basic understanding of economics.

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The Scope of Economics

Microeconomics and Macroeconomics microeconomics The branch of economics that examines the functioning of individual industries and the behavior of individual decision-making unitsthat is, business firms and households. Firms choices about what to produce and how much to charge and households choices about what and how much to to buy help to explain why the economy produces the goods and services it does. macroeconomics The branch of economics that examines the economic behavior of aggregates income, employment, output, and so on on a national scale.

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The Scope of Economics

Microeconomics and Macroeconomics Microeconomics is concerned with household income; macroeconomics deals with national income. Microeconomics questions how many people will be hired (or fired) this year in a particular industry or in a certain geographic area and focuses on the factors that determine how much labor a firm or an industry will hire. Macroeconomics deals with aggregate employment and unemployment: how many jobs exist in the economy as a whole and how many people who are willing to work are not able to find work.
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Microeconomics looks at the individual unitthe household, the firm, the industry. It sees and examines the trees. Macroeconomics looks at the whole, the aggregate. It sees and analyzes the forest.

The Scope of Economics

Microeconomics and Macroeconomics
TABLE 1.1 Examples of Microeconomic and Macroeconomic Concerns
Divisions of Economics Microeconomics Production Production/output in individual industries and businesses How much steel How much office space How many cars Prices Income Employment Employment by individual businesses and industries

Price of individual Distribution of goods and services income and wealth

Price of medical care Wages in the auto Price of gasoline industry Jobs in the steel Food prices Minimum wage industry Apartment rents Executive salaries Number of Poverty employees in a firm Number of accountants Aggregate price level National income Employment and unemployment in the economy Total number of jobs Unemployment rate

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Macroeconomics

National production/output

Total industrial output Consumer prices Gross domestic Producer prices product Rate of inflation Growth of output

Total wages and salaries Total corporate profits

The Scope of Economics

The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics Econometrics Economic development applies statistical techniques and data to economic problems in an effort to test hypotheses and theories. focuses on the problems of low-income countries. What can be done to promote development in these nations? Important concerns of development economists include population growth and control, provision for basic needs, and strategies for international trade. traces the development of the modern economy. What economic and political events and scientific advances caused the Industrial Revolution? What explains the tremendous growth and progress of postWorld War II Japan? What caused the Great Depression of the 1930s? uses psychological theories relating to emotions and social context to help understand economic decision making and policy. Much of the work in behavioral economics focuses on the biases that individuals have that affects the decisions they make.
Continued...

Economic history

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Behavioral economics

The Scope of Economics

The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics Environmental economics studies the potential failure of the market system to account fully for the impacts of production and consumption on the environment and on natural resource depletion. Have alternative public policies and new economic institutions been effective in correcting these potential failures? examines the ways in which households and firms actually pay for, or finance, their purchases. It involves the study of capital markets (including the stock and bond markets), futures and options, capital budgeting, and asset valuation. is grounded in philosophy and studies the development of economic ideas and theories over time, from Adam Smith in the eighteenth century to the works of economists such as Thomas Malthus, Karl Marx, and John Maynard Keynes. Because economic theory is constantly developing and changing, studying the history of ideas helps give meaning to modern theory and puts it in perspective.

Finance

The history of economic thought

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Industrial organizationlooks carefully at the structure and performance of industries and firms within an economy. How do businesses compete? Who gains and who loses?
Continued...

The Scope of Economics

The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics (continued)

International economics

studies trade flows among countries and international financial institutions. What are the advantages and disadvantages for a country that allows its citizens to buy and sell freely in world markets? Why is the dollar strong or weak? deals with the factors that determine wage rates, employment, and unemployment. How do people decide whether to work, how much to work, and at what kind of job? How have the roles of unions and management changed in recent years? analyzes the economic function of legal rules and institutions. How does the law change the behavior of individuals and businesses? Do different liability rules make accidents and injuries more or less likely? What are the economic costs of crime? examines the role of government in the economy. What are the economic functions of government, and what should they be? How should the government finance the services that it provides? What kinds of government programs should confront the problems of poverty, unemployment, and pollution? What problems does government involvement create?

Labor economics

Law and economics

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Public economics

The Method of Economics

positive economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It describes what exists and how it works. Ex: What determines the wage rate for unskilled workers? What would happen if we abolished the corporate income tax? normative economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics.
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Ex: Should the government subsidize or regulate the cost of higher education? Should we reduce or eliminate inheritance taxes?

The Method of Economics

Descriptive Economics and Economic Theory

Positive economics is often divided into descriptive economics and economic theory. descriptive economics The compilation of data that describe phenomena and facts. economic theory A statement or set of related statements about cause and effect, action and reaction.
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Economic theory attempts to generalize about data and interpret them. It can also arise from observation.

The Method of Economics

Theories and Models 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. Ex: Income is a variable- it has different values for different people and different values for the same person over time. Economic models are abstractions that strip away detail to expose only those aspects of behavior that are important to the question being asked. The principle that irrelevant detail should be cut away is called Ockhams razor.

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The Method of Economics

Theories and Models

All Else Equal: Ceteris Paribus ceteris paribus, or all else equal A device used to analyze the relationship between two variables while the values of other variables are held unchanged. Example: What is the impact of a change in gasoline price on driving behavior, ceteris paribus, or all else equal? If gasoline prices rise by 10%, how much less driving will there be assuming that population, income, public transportation etc. do not change?

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The Method of Economics

Theories and Models Expressing Models in Words, Graphs, and Equations Sometimes words are sufficient to express the essence of a theory, but often it is necessary to be more specific about the nature of a relationship. The most common method of expressing the quantitative relationship between two variables is graphing that relationship on a two-dimensional plane. Quantitative relationships between variable can also be presented through equations. For ex, suppose that we discover that over time, households collectively spend, or consume, 90% of their income and save 10% of their income. Then, we could write: C=0.9Y and S=0.1Y where C:consumption, S:saving, Y:income

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The Method of Economics

Theories and Models Cautions and Pitfalls: In formulating theories and models, it is especially important to avoid two pitfalls: The Post Hoc Fallacy
post hoc, ergo propter hoc Literally, after this (in time), therefore because of this. A common error made in thinking about causation: If Event A happens before Event B, it is not necessarily true that A caused B.

The Fallacy of Composition

fallacy of composition The erroneous belief that what is true for a part is necessarily true for the whole.
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For ex, theories that seem to work well when applied to individuals or households often break down when they are applied to the whole.

The Method of Economics

Theories and Models Testing Theories and Models: Empirical Economics

empirical economics The collection and use of data to test economic theories.

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The Method of Economics

Economic Policy

Criteria for judging economic outcomes: 1. Efficiency 2. Equity 3. Growth 4. Stability

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The Method of Economics

Economic Policy Efficiency efficiency In economics, allocative efficiency. An efficient economy is one that produces what people want at the least possible cost. The simplest example of an efficient change is a voluntary exchange. If you and your friend each want something that the other has and you agree to exchange, you are both better off. When a company reorganizes its production or adopts a new technology that enables it to produce more of its product with fewer resources, without sacrificing quality, it has made an efficient change.

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The Method of Economics

Economic Policy Equity equity Fairness. It is impossible to define equity universally, as each individual might have a different on what is fair. Even so, public policy makers judge the fairness of economic outcomes all the time. Most social welfare programs are created in the name of equity.
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The Method of Economics

Economic Policy Growth 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 increase. Some policies discourage economic growth, and others encourage it. Tax laws, for example, can be designed to encourage the development and application of new production techniques. Building roads, highways, bridges and transport systems in developing countries may speed up the process of economic growth.

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The Method of Economics

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

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Questions

1) The reason that opportunity costs arise is that A) an economy relies on money to facilitate exchange of goods and services. B) resources are scarce. C) there are no alternative decisions that could be made. D) people have limited wants.

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Questions

2) Sunk costs are A) costs that cannot be avoided, because they have already been incurred. B) the costs of what we give up when we make a choice or a decision. C) the additional costs of producing an additional unit of a product. D) the additional costs of consuming an additional unit of a product. 3) For each of the following, list whether the topic is microeconomic or macroeconomic in nature: (a.) The price of gasoline. (b.) The national unemployment rate. (c.) The quantity of new cars sold each year. (d.) The wage rate paid to steel workers. (e.) The amount of national output in an economy.

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Questions

4) An efficient market is a market A) in which everyone always gets what they want. B) in which profit opportunities are eliminated almost instantaneously. C) in which profits are always very high and persistent. D) in which opportunity costs are zero. 5) The statement "the unemployment rate is 5.1%" is an example of a A) positive statement. B) value judgement. C) normative statement. D) non-verifiable statement.
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Questions

6) The economy was expanding during all of the years that I was a student, but as soon as I graduated, the economy contracted. Therefore, the labor market was waiting until I started looking for a job to contract. This statement is an example of A) ceteris paribus fallacy. B) post hoc, ergo prompter hoc fallacy. C) fallacy of composition. D) fallacy of inductive reasoning.

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