2005, Southwestern

Slides by Pamela L. Hall

Western Washington University
Chapter 1

Introduction
2
Introduction
Knowledge of economic theory provides a road map for
Understanding how economy operates
How individuals interact as groups of consumers and producers
Road map describes how a decentralized system of
resource allocation
Can result in efficiently allocating limited resources
Ability to understand economic theory and apply it to
everyday choices
Will provide you with power to make correct choices and understand
choices made by others
Road map can aid us in addressing practical, realistic
problems such as
Environmental degradation
Cartels
Dishonest used car salespeople
Discrimination
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Introduction
Epistemology
Field of philosophy that critically investigates nature, grounds, limits,
and criteria or validity of human knowledge
A theory of cognition
Act or process of knowing
Economic theory contains a great deal of epistemology
Theory for examining how human behavior affects economic
decisions
For example, economists have worked to specify minimal number of
assumptions required for characterizing an individual consumers
preferences
Applied economist
Combines economic theory with knowledge of institutions and
environment to address practical problems
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Economics Defined
Riches in terms of fewness of wants are what economics is
all about
Unfortunately we are unable to satisfy all of our wants
there are limits
For a society these limits take form of scarce resources
For example, land, water, labor, and physical capital
Economics is study of how to allocate these limited
resources to satisfy unlimited wants
Economics is a social science, in contrast to a natural
science
Deals with human society or its characteristic elements, such as
individual, family, or state
Scarcity means there are not enough resources to satisfy
every possible demand

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Economics Defined
Economics
Social science concerned with allocation of scarce
resources for satisfying unlimited wants
E.g., with a federal budget surplus, do we pay down national
debt, cut taxes, maintain social programs, or fly to Mars?
Society
Interaction of individuals within an environment
E.g., United States and other countries
Social welfare
Happiness for society as a whole
E.g., economists have suggested modifications to a countrys
gross national product as a surrogate measure for social welfare
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Economics Defined
Local bliss
Social welfare is maximized for a given resource
constraint
E.g., a time of peace and prosperity
Global bliss (or bliss)
There are no resource constraints and all wants are
satisfied
E.g., our dreams
Agent
Household or firm within an economy
E.g., you
Economy
Group of agents interacting to improve their individual
and joint satisfaction
E.g., interaction of buyers and sellers in a free society
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Economics Defined
Using resources in one way has an opportunity cost
of not being able to use them in another way
For example, opportunity cost of allocating time for
studying is lost enjoyment of seeing a movie instead
Scarce resources are continuously changing
through time
Nonrenewable resources are declining
Renewable resources may increase or decline over time
Capital, both human and physical, will depreciate over
time
Must be augmented to maintain or increase present levels
Change in resources is a constraint (limitation) that
prevents complete satisfaction
Assuming individuals wants are insatiable
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Economics Defined
Individuals wants are also continuously changing
Depending on age, location, and even time of day
Economics is concerned with way society chooses to
allocate a continuously changing set of limited resources
Among a continuously changing set of unlimited wants
Would you be sorry if all your wants were satisfied?
Yes, because tomorrow these current wants will change
Economics is a philosophical inquiry into process of
resource allocation
Outlines how a society allocates its scarce resources to achieve
prosperity and well-being for its citizens
Objective of economics
Maximize happiness for society as a whole (social welfare) subject to
limited resources
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Economics Defined
Economics provides a theory for determining
What commodities to produce
When to produce them
How to produce them
For whom to produce them
Theory describes economic environment in which agents (households
and firms) interact
Knowledge of this environment provides an understanding of how an
economy operates
Economic theory offers both an explanation for and predicts how agents
within an economy operate
Must understand this operation of an economy to make efficient decisions on how
to allocate resources
With understanding of economic theory, ability to explain, predict, and
control economy is possible
Economic theory could be used as a basis for
Design of policies by governments wishing to control outcome of a program or
As a critique of control actions governments might take
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Economics Defined
For example, economic theory can describe
How price of oil affects auto production
Why a large increase in gasoline price results in little
reduction in demand for gasoline
Why a cattle rancher will stay in business even if she is
losing money
Why a firm with monopoly power can charge a higher
price for its commodity than a competitive firm
Economic theory is a very nonlinear use of
language
Full implications are more than just sum of parts
Makes it a very powerful and exciting field of study
Why study economics?
Microeconomic theory offers solutions to practical
problems
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Taxonomy of Economics
Economics may be classified into a number of
divisions
Economic philosophy
Positive and normative
Major fields
Micro and macro
Economists tend to specialize in one of the major
fields
In their applications they will generally employ both
positive and normative economic philosophies
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Microeconomics and
Macroeconomics
Microeconomics
Concerned mainly with economic activities of individual consumers
and producers or groups of consumers and producers, known as
markets
Examples include
Consumers demand for food
Cost to a firm for a particular volume of production
Per-unit price a firm charges for a specific volume of its output
Macroeconomics
Concerned with behavior of economic aggregates or economy as a
whole
Examples include
Total volume of output for a nation
General level of prices and employment
Total level of income and expenditures
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Microeconomics and
Macroeconomics
Complement each other
Microeconomics deals with efficient allocation of resources
within an economy
Macroeconomics deals with maintaining a stable economic
environment resulting in full employment with stable prices
If macroeconomists are unable to maintain full employment of
resources
Microeconomists need not worry about efficiently allocating these
resources
Since unemployed resources are not scarce or limited
Microeconomics is of limited use unless resources are fully employed
Reverse is also trueif microeconomists are unable to efficiently
allocate resources
Even with fully employed resources social welfare will not be maximized

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Microeconomics and
Macroeconomics
Fallacy of composition states
What is true of parts is not necessarily true of whole
In terms of economics, generalizations made at microeconomics
level may not always be true at macroeconomics level
For example, rising unemployment may result in workers
increasing their savings
Microeconomics would predict an increase in individual savings
However, unemployed may decrease their savings to maintain their
living standards
Macroeconomic effect of combining workers and unemployeds
savings levels may result in a decrease in savings
Called Paradox of Thrift
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Microeconomics and
Macroeconomics
Converse of fallacy of composition is fallacy of division
What is true of whole is not necessarily true of the parts
Generalizations made at macroeconomic level may not always be
true at microeconomic level
For example, in aggregate (macro), level of prices may be
stable
Specifically, there is no inflation, defined as a general rise in prices
However, in a particular market (micro), prices may be rising rapidly
Micro- and macroeconomics are not distinct areas of study
Both can be used to investigate same policy action
For example, an increase in government taxes affects consumers
and producers can be analyzed with
Microeconomic tools
Investigate effect on markets for specific commodities, such as housing or
automobiles
Macroeconomic tools
Analyze effect on aggregate employment, inflation, and national income
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Positive and Normative Economics
Positive economics
Concerned with what is, was, or will be
Considers actual conditions that have occurred or will occur in an economy
If two people disagree over positive statements in economics
Should be able to settle their controversy by logical thinking and appealing to
facts
For example, the statement A 10% increase in the price of gasoline will have no
effect on the number of vacationers going skiing, is a positive statement
Can be tested by empirical research
Number of skiers before price hike can be compared with number of skiers after
Normative economics
Concerned with what ought to be
Involves value judgmentsstatements about what is good and what is bad,
what ought to have occurred, or what ought to occur in an economy
If two people disagree over normative statements
They are disagreeing over value judgments and may not be able to reach an
agreement
For example, Only Bohemian residents should be allowed to vacation in Bohemia, is a
value judgment that cannot be tested
Empirical evidence cannot be used to destroy ones belief about the issue

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Applied Economics
Applied Economics is closely related to normative and positive
economics
Belongs to neither category but to a category called art of economics
Distinction dates back to father of John Maynard Keynes, John Neville
Keynes
Positive economics is study of what is and the way the economy works
Pure science, not applied economics
Normative economics is study of what should be
It is also not applied economics
Art of economics is applied economics that accepts some set of goals
determined in normative economics
Discusses how to achieve those goals in reality, given insights of positive
economics
Relates conclusions derived in positive economics to goals determined in
normative economics
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Applied Economics
Positive economics is abstract thinking about abstract problems
Immediate or even future relevance is of little or no concern to a positive
economics researcher
Methodology for art of economics is broader, more inclusive, and less
technical than methodology for positive economics
Requires a knowledge of institutions and of social, political, and historical
phenomena
Mechanisms for using available data in addressing current economic
problems are developed as economic art
Applied economics relies on all other disciplines to support positive
economics
Engineering, biology, and ecology are improving technology
Helps produce more desirable commodities from limited resources
Mathematics, computer science, and statistics are developing new tools for
advancing both applied economics and positive economic theory
Applied economics incorporates theories from political science, sociology,
and psychology


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Models
Economics is based on belief that most behavior can be
explained
By assuming agents have stable, well-defined preferences
Make rational market choices consistent with these preferences
Economics is distinguished from other social sciences by its
general acceptance of this belief
Paradigm in economics
Foundation for building economic models
Models are basic tool used by scientists to increase our
understanding of real world
Simplified representations of reality
Reality is simplified in different ways in a model
Depending on objectives of model and particular situation
For example, a map is a simplified model of world, but not all information
about world can be placed on one map
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Assumptions
A model is used to simplify reality from which conclusions are logically deduced
about some system
A system is a group of units interacting to form a whole
For example, consumers and producers interact to form a market system
Assumptions are assertions about system properties that are observable in real
world
Can be evaluated for their degree of realism
Properties are traits and attributes of a system
A model describes essential features of a system, based on theory, in a way that
is simple enough to understand and manipulate
Close enough to reality to yield meaningful results
Consider a model of consumer behavior with following assumptions
Consumer is rational and attempts to maximize satisfaction (utility)
Consumer has a fixed level of income
Commodities (goods and services) vary continuously, and utility consumer derives
from them is measurable
Consumer has a given set of preferences for these commodities
Commodity prices are constant
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Assumptions
Based on this set of assumptions, can conclude that a consumer will
maximize utility
By equating marginal (additional) utility per dollar for all the commodities he
purchases
In this model, variablescommodity prices, income, and consumer
preferencesare assumed to influence consumers purchases of
commodities
Called exogenous variables
Based on economic theory, we can develop a model where these
exogenous variables cause change in other variables
Called endogenous variables (in this case, consumers purchases)
Assumptions characterize type of world for which a model is intended,
but model is not an exact representation of reality
For example, when at supermarket you do not count level of utility you
receive per unit of commodity
However, a model provides a reasonable abstraction
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Assumptions
Abstracting from reality is part of scientific method
Minimizes influences of personal and cultural beliefs in
explaining reality
Economists employ scientific method to develop
and test models that are accurate representations
of reality
Hypothetical models are important in any science
Even if these models are artificial, they are useful
Real test of such models is whether they lead to
conclusions that help to further scientific objectives
Explanation, prediction, and control

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Analysis
Value of economic models is not in how realistic are their assumptions
But in how useful are conclusions derived from them
As illustrated in Figure 1.1, economists employ scientific method for analyzing
these models
Considering reality (the real world) as a starting point, an economist reduces the
complexities of reality to manageable proportions
By developing a model of a real-world system based on economic theory
Results in a logical model suited to explain system observed
By logical argument (deduction), logical or model conclusions can be derived
Hypotheses of relationship among variables
Hypotheses are then transformed into conclusions about real world
Economists may also employ econometrics (application of statistics to
economics) to analyze reality
For developing an econometric model, economists use experimental abstraction
based on economic theory, which leads to experimental design
Model is then useful in testing hypotheses derived from economic theory
Theoretical and econometric models complement each other in developing real-
world conclusions

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Figure 1.1 Scientific
method
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Analysis
Relative emphasis on theoretical versus statistical models has changed over
time
Greek tradition proves things with abstract principles (theoretical models)
For example, proof of Pythagorean Theorem does not depend on particular size of a right
triangle
Babylonian tradition discovers things by computation
Such as fact that a million different right triangles all have same relation among squares of
their sides
Greek tradition prevailed in works of past Nobel laureates such as Paul A.
Samuelson and Kenneth J. Arrow
Applied mathematical reasoning to a minimum of data
Ever-decreasing cost of computation due to advanced technology has increased
cost of Greek science (theoretical modeling) relative to Babylonian science
(econometric modeling)
Elegant analysis still costs as much time and effort as it ever did, but number
crunching becomes ever cheaper
The kinds of practical questions consumers, firms, governmental policymakers,
and economists are asking are more amenable to answers from Babylonian
economics
For example, an econometric model can show magnitude of a reduction in pollution
from a change in a pollution standard
In contrast, a theoretical model will generally only provide an indication of direction of
change and not magnitude
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Tools
Tools employed for developing theoretical models and deriving
conclusions are prose, geometry, mathematics, and computer
programming
Prose is ordinary language of people in speaking or writing
Disadvantage of prose was that key features of a model were lost as it was
verbally transmitted or imitated among individuals
Written communication solved this problem
For relatively detailed models a great deal of writing was required
Geometry alleviated this limitationa picture is worth a thousand words"
Geometric illustrations that complement writing allow a model to be
communicated and conclusions to be developed with greater efficiency
Geometry is an excellent tool for describing a model with two variables, such as
price and quantity
Unfortunately, geometry is limited by its dimensions
Geometry is not able to represent fourth, fifth, or any higher dimension
Required of a model with more than three variables
Mathematics allows us to enter worlds of higher dimensions and explore
their vast areas with models designed to provide insights into their workings
If a picture is worth a thousand words, mathematics is worth the universe
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Tools
A model can always be communicated without
mathematics
But mathematics greatly reduces a models description
and expresses it in a very concise manner
As mathematical models become more complex
Analytical solutions to models become difficult or
impossible
However, advancement of computer programming
provides numerical solutions to these complex
models
Computer programs have provided solutions to some
models that previously could not be solved
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Models in Scientific Explanation,
Prediction, and Control
An educated person is someone who is able to explain relationships
among facts
Neither a list of facts nor a compilation of summary statistics from a
survey are explanations
Facts and statistics are generally called data
An explanation is general relation underlying data
Data are interpreted or explained by applying theory to account for relationships
among variables
If a model does well in explaining relationships, it can be used for
prediction
Deriving some conclusion before it is observed
Distinction between explanation and prediction
Explanation is a conclusion observed first, with a model in support of the
conclusion provided afterward
Prediction is a conclusion deduced from a model before conclusion is
observed

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Control is altering of one or more exogenous variables in a model to predict a
particular outcome
Examples include
Changing price of a commodity to predict change in a consumers purchases
Changing pollution standard in a model to predict change in pollution
For purposes of control, a model that provides valid explanations as well as
accurate predictions is required
Based on models developed in following chapters, we investigate changes in
(control of ) exogenous variablessuch as prices, wages, and income
By comparing one equilibrium position to another
Called comparative statics analysis
Table 1.1 lists a collection of optimization models along with comparative statics
analysis developed and discussed in following chapters
All optimization models involve either maximizing or minimizing an objective function
Given a fixed level for exogenous variables, endogenous variables are varied to
determine optimal level of objective function
Generally, objective function is subject to some constraint
Such as limited income or a given level of technology
Models in Scientific Explanation,
Prediction, and Control
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Table 1.1 Collection of optimization
models developed in this text
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Development of Microeconomics
Marshallian-cross analysis
Developed in 1880 by English economist Alfred Marshall
Figure 1.2 shows an illustration of Marshallian cross
Per-unit price of a commodity, p, is measured on vertical axis and quantity of
commodity, Q, is measured on horizontal axis
Marshallian cross is represented by market demand and supply curves
As price decreases, quantity demanded for a commodity by consumers is
expected to increase
Results in a downward or negatively sloping demand curve
Firms supplying this commodity are expected to react to this price decline by
Decreasing supply of commodity
Results in an upward or positively sloping supply curve
Point of intersection (crossing) represents market equilibrium level of price and
quantity
Quantity Supplied = Quantity Demanded
No incentive for consumers or firms to change their market behavior
Market-clearing price (p
e
) is most efficient mechanism for allocating
scarce resources among unlimited wants
Marshallian-cross analysis has been applied to a wide range of social
behavior
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Figure 1.2
Marshallian Cross
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Partial-Equilibrium Versus General-
Equilibrium Models
Marshallian cross is only a partial-equilibrium model
Only considers one market at a time rather than all markets in an economy
For some questions, this narrowing of perspective gives valuable insights
and analytical simplicity
However, for broader questions about efficiency and welfare implications of
economic activities
Narrow viewpoint may prevent discovery of important interrelations
For answering broader questions, a general-equilibrium model is
required
Models whole economy or some major subset
French economist Leon Walras created basis for such an investigation
by representing economy with a number of simultaneous equations
Created model that permits effects of a change in one market to be carried
through into other markets
In a sense, current macroeconomics is simply an example of applied
general equilibrium analysis