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Defining Economics

! ! Economics is the study of rational choice under conditions of scarcity. Opportunity cost is the best alternative that you give up when you make a choice. Remember that scarcity is an imbalance between what people want and what is freely available. The chart on the left explains the difference between "scarce" and "not scarce." The reason that breathable air and livable space are scarce is that people want those things. The reason that garbage is not scarce is that people do not want garbage. Rational choice means people making calculated, self-interested choices after weighing the costs and benefits of those choices. A rational agent chooses the action that is most self-satisfying.

All choices come with a cost. The real cost of choosing something is not the money you pay to get it. The real cost is the value of the next-best alternative that you gave up to make the choice you did. This is called the opportunity cost.

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What Economists Do
! ! ! Economics employs the scientific method by asking questions, producing explanations (models), and forming hypotheses. Economists have integrated into the fields of business, government, and academia. Positive economics is predictive, or descriptive, whereas normative economics is judgmental, or evaluative.

The illustration on the right exemplifies the questions economists ask. Economists must explore all possibilities in their efforts to establish optimal economic conditions.

The example of the economic model on the left shows us how economists might answer the questions they face.

After creating the hypothesis, economists must test it in the real world by collecting data and comparing it to the model. If the data matches the predictions of the model, economists have explained a condition in the real world.

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Economists in business help make forecasts about when to launch new products and enter foreign markets. Government economists collect data, conduct research, devise plans to finance the national debt, and make decisions regarding implementation of new taxes. Economists in academia teach, conduct research, and publish and present reports of their findings. Positive economics is economics as a predictive, descriptive social science. It answers specific questions in economics. Positive economics seeks to answer the question, How will the world work? Normative economics is about making judgments or evaluations. It is about norms, or standards of judgment. Normative economics seeks to answer the question, How should the world work?

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Macroeconomics and Microeconomics


! ! ! ! ! Microeconomics is the study of the decision-making process of individuals. Macroeconomics is the study of aggregate decision making. The players in the economy include households, businesses, government, and foreign trade. Nominal variables are measured in terms of actual dollar values. Real variables are measured in terms of physical goods and services. The analogy illustrated on the left explains the difference between microeconomics and macroeconomics. Microeconomics answers questions such as, If wages rise, will households supply more or less labor? Macroeconomics addresses questions like, What happens to employment when overall productivity increases? Macroeconomics also examines the Federal Reserves decisions to control the money supply and their effects on the economy. Consider the chart on the left. This chart shows the players in the economyhouseholds, businesses, government, and net exportsand the way in which they are studied in microeconomics and macroeconomics.

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When we place dollar values on goods and services, the values are nominal variables. We use real variables, however, to measure actual, tangible goods and services. Look at the example on the left. When we add the nominal values of an apple and a cup of coffee, we calculate a total value of $1.75. It is much more difficult, though, to calculate the total value of an apple and a cup of coffee based on real values.

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Overview of Economic Systems


! ! ! ! Economic systems answer several questions: What will be produced? How will it be produced? Who will receive the goods and services? In a laissez-faire system, citizens make decisions for themselves. In a planned system, life choices are governed by a central planner. In the real world, all economies are mixed systems, and the role of the government is to strike a balance between the two. The term laissez-faire is French for let alone or hands off. In a laissezfaire system, individuals are motivated by price. Consider the example on the left. This woman faced with an employment decision will most likely choose the higher-paying job. People in a laissez-faire system have maximum individual freedom, but may inadvertently impose costs on others. In a planned system, life choices are limited and governed by a central planner. The central planner may find it difficult to gather information and motivate the individuals within the economy. A central planner may also abuse his/her authority.

In the real world, all economies are mixed. The illustration on the left shows the spectrum of economic systems. Notice that the United States lies relatively closer to the laissez-faire end than China does. The role of the government is to regulate the balance of laissez-faire and planned systems.

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Case Study: The Work of Adam Smith


! ! Adam Smith (b. 1723d. 1790) is called the father of modern economics. The Theory of Moral Sentiments (1759) and An Inquiry into the Nature and Causes of the Wealth of Nations (1776) are two of Smiths most important works. Smith believed that the pursuit of self-interest leads to common wealth. Adam Smith was born in Kirkcaldy, Scotland in 1723. He attended Oxford University where he studied moral philosophy, the study of the right way for people to live. He became a professor of moral philosophy at Glasgow University and one year later was appointed chair of moral philosophy. In the first of his two major works The Theory of Moral Sentiments (1759), Smith wrote that human nature is inherently compassionate and cooperative. Because of this nature, Smith believed that we are capable of producing great wealth. Smith published his second major work in 1776, An Inquiry into the Nature and Causes of the Wealth of Nations. In it he proclaimed that individuals are led by

an invisible hand to pursue self-interests and create a wealthy, productive economy.

The list on the left addresses some of Smiths concerns. These scenarios are certainly possible in the real world, but Smith believed that human nature without government intervention is capable of producing great wealth.

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