n CHAPTER OBJECTIVES

7.State the difference between macroeconomics and microeconomics and between positive and normative economics.

n KEY TERMS

•scarcity•

n CHAPTER OUTLINE

I.WHAT IS ECONOMICS?—Economics is defined as the science of how individuals and societies deal with the fact that wants are greater than the limited resources available to satisfy those wants. In other words, economics is the “science of scarcity.” The definition introduces several key concepts in economics that are discussed in more detail in this chapter.

A.SCARCITY—The first key principle in economic analysis is that resources, such as time, land, labor, and the like, are in limited supply. Scarcity means that our wants outstrip the limited resources available to satisfy those wants at any point in time. Scarcity is the basic economic problem confronting all individuals and societies. For this reason, economics is defined as the science of how individuals and societies deal with the fact that wants are greater than the limited resources available to satisfy those wants. 

B.What Do Economists Study?—

Most economists study problems relating to prices, interest rates, inflation, exchange rates, and so on,

their inquiries can also lie in the fields of crime, war, law, and other areas.

The reason that economics can be applied to traditionally non-economic areas is that economists apply the economic way of thinking to these fields of study.

C.What Is an Economic Way of Thinking?—

Economists try to explain the process of how resources are allocated and what determines the prices that allocate resources.

We will explore in the class- economists have a certain way of viewing the world.

D.Why Study Economics?—There are many reasons to study economics. Three benefits of studying economics are

1.Economics can be used to alleviate real-world problems—such as poverty.

2.Economics can help people to understand the world around them—and that process of understanding can be a reward in and of itself.

3.Economic ideas shape political and social decisions and the laws that affect us everyday—a fact that Keynes pointed out. Each congressional and presidential election poses one set of economic ideas against another. The economists who originally put forward those ideas are influencing your life, so it is important to understand what economists think!

E.Why Study Economics in the 2000's?—Economic change in Russia, Eastern Europe, and China, free trade agreements such as NAFTA or GATT, and changes in interest rates, prices, and exchange rates all affect your daily life. 

Economic change is pervasive, and understanding why these changes occur and how they impact your life should be of great importance to you. 

Moreover, economic change is reshaping and shrinking the economic world. Not only are foreign goods increasingly available in the United States, but economic change in other countries can directly influence our own economy. 

A recession in Europe or Asia will decrease demand for U.S. imports. 

Economics and business are becoming the international language today. 

II.Thinking Like an Economist—The principal problem in economics is limited resources and unlimited wants. The condition is called scarcity.

A.Defining Economic Goods—Economic goods can be viewed in three different ways: in terms of their utility, whether they are tangible or intangible, and the types of resources that are used to produce those goods.

1.GOODS—A good is anything from which individuals receive utility, or happiness.

By utility we just mean usefulness

Bads—The text uses this term not found elsewhere: A bad is anything from which individuals receive disutility, or unhappiness, such as pollution and garbage.

No rational individual will voluntarily consume a bad.

3.Tangibility—Goods are tangible if they can be touched (such as a car) and intangible if they are a quality or a feeling (such as friendship).

B.Resources—The production of all goods and services requires the input of some RESOURCES, OR FACTORS OF PRODUCTION. Economists typically divide these productive factors into four categories: land, labor, capital, and entrepreneurship.

1.LAND—includes all natural resources, such as minerals, forests, water, and unimproved land.

2.LABOR—the physical and mental talents that people contribute to the production process.

3.CAPITAL—consists of produced goods, such as machinery, tools, buildings, and the like. Capital can be used as inputs for further production.

4.ENTREPRENEURSHIP—refers to the unique talent that some people have for organizing inputs into the production of goods and services and to search for new business opportunities and ways of improving existing processes.

C.SCARCITY IMPLIES RATIONING—Because wants are unlimited and resources are limited, our wants will never be met. How do we decide who gets these finite resources?

Price serves this function. A means of allocating or rationing the resources that exist must be created.

When you purchase a good, you are giving up your own resources (money) in order to obtain the good.

The price determines how much you have to give up, and ensures that only those who are willing and able to give up a sufficient amount of their own resources will receive the good.

D.Scarcity and Competition—Because goods are limited, individuals compete to obtain the goods that are available, and studying this competitive process is what an economist does.

1.Economists want to know how people and businesses compete with one another—Certainly, price is a very important rationing mechanism, but other factors such as influence, laws, government, charm, and so on can ration resources.

Economists want to study all rationing devices.

2.Economists want to know why people make the decisions they do—Why are students willing to devote years to schooling?

Usually, to get a better job, but an economist would want to determine whether this investment was a productive one.

E.Opportunity Cost—Another important concept is that choice implies opportunity cost.

OPPORTUNITY COST is defined as the value of the best alternative forgone when a decision is made. 

Several examples can be given.

1.The opportunity cost of reading this chapter is the value of what is forfeited—This might be measured in the lost income for a student who could be working at a job, or a lost hour of television or eating a pizza.

The higher the opportunity cost of doing something, the less likely it will be done.

2.The Author’s example typical of economist’s thinking The Revolutionary War—Another example of opportunity cost can be seen in the Revolutionary War. The British army faced the problem of desertion, so the army’s solution was to have the soldiers wear bright red uniforms. Unfortunately, this had an opportunity cost. The red uniforms were an easy target to shoot at during the war. The red uniforms may have decreased the number of deserters, but they increased the number of casualties.

F.Opportunity Costs: Thinking in Terms of What Would Have Been—Another aspect of the economic way of thinking is to try to understand what would have been if a certain event had not happened and to measure the opportunity cost of that event. The interstate highway system can provide a couple of examples.

1.What if the interstate highway system did not exist?—People would still be able to travel across the country (they certainly did so before the 1950s); however, it would be more costly to do so. 

Asking how much more costly travel would have been is exactly the type of question an economist would ask. The difference between what it costs now to travel and what it would have cost is the benefit.

2.The interstate highway system was not free—It was paid for with tax dollars.

An economist would ask, “If the interstate highway system had not been built, how would people have spent the money?” In other words, what was the opportunity cost? Thar oprion that they gave up is the opportunity cost of the project.

Did the benefits exceed the costs? This is the economic way of thinking!

3. An example of economic thinking and opportunity costs: Economics in Popular Culture—Young people attend college to increase their lifetime incomes. Young people with exceptional skills, such as rock stars, movie stars, or fashion models, evaluate college differently. To most students, the increased income (benefit) will outweigh the opportunity cost they incur to attend class.

G. Economics in Everyday Life—Opportunity costs may determine the amount that people sleep. People who earn high incomes have high opportunity costs of idle time, and therefore should sleep less than people with low income. 

Differing with the author- low income persons might also sleep less because they need to work harder to acquire the goods for survival. In other words They attach a very high utility to the goods they can acquire with an extra unit of work.

On the other hand, high income people, don’t need tangible goods. The utility of an additional unit of food is less to them than to a low income person. Rich people can afford liesure.

Low income people may sleep longer because they work harder.

H. Thinking in Terms of Costs and Benefits and Decisions Made at the Margin—

When economists study individuals’ decisions, they study decisions at the margin, the additional cost or benefit that a person has.

Economists refer to these as the marginal costs and the marginal benefits of the decision.

The reason for studying decisions at the margin is that it is the tradeoff between marginal benefits and marginal costs that shape economic decisions.

We do not generally choose between studying and not studying in total, but we do ask how much will an additional hour of studying raise my grade?

Similar questions: If the store opens an hour earlier, by how much will revenues increase?

If I hire this person, how many more goods will we be able to produce?

I.Thinking in Terms of Unintended Effects—

Life doesn’t always go as we expect or hope.

Sometimes the choices we make can produce the opposite result of what we had intended. This happens in economics as well.

1.Minimum Wage—What if the government raises the minimum wage to a level higher than what you are currently earning?

Initially, you would be happy, but what if your employer told you he could no longer afford to pay you at the higher wage rate, and he had to lay you off?

In this case, you would definitely not benefit from the government’s new law.

J.The book identifies six ways that students can think like an economist:

1.Analyze scarcity and its effects.

2.Look at the opportunity costs of economic decisions.

3.Try to determine what would have been if the event you are analyzing had not occurred.

4.Measure the benefits and costs of your actions.

5.Analyze decisions in marginal terms.

6.Try to determine the unintended effects of actions.

III.ECONOMISTS BUILD AND TEST THEORIES 

A.The Uses of Theory—Everyone uses theories, or models, to explain things they observe and to predict the future.

most theories are attempts to explain observable facts.

A theory is built on (only) the critical factors that the theorist believes affect the observed fact.

B.Abstraction: Getting More for Less—

Because we focus only upon a limited number of variables, we are reducing reality to a simplified explanation, such as:

By simplifying, we leave out a great deal of specific information, but we answer the basic question—and that is the goal of theory-building.

It is no different than leaving out most streets when drawing a map to guide a friend. They need to get from A to B, not learn the layout of the neighborhood.

C.Parts of a Theory

1.Deciding What to Explain or Predict—The first, and most critical, part of a theory is to determine clearly what it is that we wish to explain or predict.

2.Variables—Variables are magnitudes that can change, or take on different values, such as the height of any individual chosen from a crowd, or the temperature on a given day. Variables are the most basic elements of a theory and are what we use to explain our observed outcome and/or predict the future.

3.Assumptions—Every theory must make some basic assumptions about the nature of reality.

4.Hypotheses—A hypothesis is a conditional statement specifying how two or more variables are related. Typically, it follows the “if-then” form—for example,

5.Test the Theory’s Predictions—Predictions are statements that logically follow from the assumptions and hypotheses of the theory. 

D.Formulating and Testing Theories: The Scientific Approach—The approach typically used in building, testing, and refining economic theories, as illustrated in Exhibit 2. Formulating and testing theories follows six discernible steps:

1.Decide what it is you want to explain or predict.

2.Identify the variables that you believe are important to what you want to explain or predict.

3.State the assumptions.

4.State the hypothesis.

5.Test the theory by comparing its predictions against real-world events.

6a.If the evidence supports the theory, then no further action is necessary (though continued monitoring and assessment is wise); but,

6b.If the evidence rejects the theory, then either formulate a new theory or amend the old theory, in terms of its variables, assumptions, and/or hypothesis.

E.Judging Theories—

There is no universally accepted means of judging theories.

most theories will be somewhat “unrealistic” because they use abstraction—that is, they will exclude some facts/viewpoints in order to concentrate upon those factors viewed as most essential. Many people would argue that any theory should be evaluated “in context.”

Milton Friedman, argue that how “realistic” the assumptions of a theory are is unimportant; what matters is how well it works.

Most economists believe that both should be present- realistic assumptions and good predictions.

F.Errors in Economic Thinking—While there are many possible mistakes that might be made in economic analysis, some stand out as likely enough and important enough to justify a special discussion.

1.Association vs. Causation—

Association does not imply causation. Two events may be associated because they happen in close proximity to each other, perhaps even with great frequency. 

However, causation implies that one observed event is responsible for the other taking place.

Cardboard boxes- production goes up just before economic booms. But cardboard boxes do not cause the economy to rise or fall.

Similarly sunspots.

2.The FALLACY OF COMPOSITION—Another common error in economic analysis is the so-called fallacy of composition—the belief that what is good for an individual (or part of the whole) is necessarily good for the group (or the whole).

3.The CETERIS PARIBUS Condition—A mistake that is often made in assessing economic theories is blaming them for not taking this or that into account.

It is important to realize that most economic theories—indeed, most theories of any nature—implicitly or explicitly utilize the ceteris paribus condition. From the Latin, ceteris paribus means “all other things held constant.” It is used in a theory to separate out the effects of that which we want to observe from that which we do not.

G.NORMATIVE ECONOMICS VS. POSITIVE ECONOMICS—

Normative economics attempts to determine what should be, whilepositive economics addresses what is:the facts.

The book claims that it focuses on positive economics, but politics occasionally creep in.

As the book says:“bear in mind that, with some issues, it is almost impossible to completely separate the two.”

H.MICROECONOMICS AND MACROECONOMICS—While most economic issues defy simple classification, for pedantic purposes we distinguish between

microeconomics—the study of human behavior and choices as they relate to relatively small units, such as the individual, the firm, the industry, or a single market—and

macroeconomics—the study of human behavior and choices as they relate to either highly aggregated markets or the economy as a whole.