Chapter 1: What is economics?

8/25/2016

Definitions understand each of these

 Economics is the social science that studies the choices that
individuals, businesses, governments and entire societies make
when they cope with scarcity and the incentives that influence and
reconcile those choices. ongoing process
 Economics is the study of how society chooses to allocate its
scarce resources to the production of goods and services in order to
satisfy unlimited wants. Scarcity is the reason to study economics
 Economics is the science which studies human behavior as a
relationship between ends and scarce means that have alternative
uses.

__What makes these definitions suitable____?

The Problem of Scarcity

 Scarcity is the condition in which human unlimited wants are forever greater
than the available supply of time, goods, and scarce resources needed to
satisfy those wants.

 Scarcity forces us to make choices over the available alternative.

The choices we make depend on incentives, a reward that
encourages a choice or a penalty that discourages a choice.

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Scarce Resources and Production

Resources or factors of production are the basic categories of inputs

used to produce goods and services.

 Land: Any natural resource provided by nature. Usable in

production of goods and services, e.g. fish, trees, air

 Labor: The mental and physical capacity of workers to produce

goods and services. 70-80% services; any human exertion

 Capital: The physical plants, machinery, and equipment used to

produce other goods. Capital goods are human-made goods that
do not directly satisfy human wants. Not consumed, long-lasting;
physical, not human capital; human capital: quality of labor force

 Entrepreneurship: The creative ability of individuals to seek

profits by combining resources to produce goods and services.
Important form of labor; organizing resources

Land Labor Capital

↓ ↓ ↓
Entrepreneurship: Organizes resources to produce
goods and services

By the above definition money by itself is __not__ capital. It is

called _financiail_capital.

 Financial Capital is the money value of paper assets, such as

stocks, bonds, or deed to a house. Financial capital by itself is
not productive; instead, it is only a paper claim on economic
capital. claim = ownership/purchasing power
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 Economics is generally divided into two main branches:
 Microeconomics is the study of the choices individuals and
businesses make, the way those choices interact in the markets,
and the influence of governments. Focuses on one
component/industry; self-interest; nothing around it changes

 Macroeconomics is the study of the performance of the national

economy and the global economy. National = GDP, measurement
of financial production in country; values of all goods and
services measured in ($); has foundation of microeconomics

Two Big Economic Questions

A. How do choices wind up determining what, how, and for whom

goods and services are produced? Ownership and control; dominantly
owned and controlled by (1) private sector = capitalism, (2) social
sector = socialism

 This question is generally referred to as the “Three Fundamental

Economic Questions” that all economies must answer.

1. What to Produce?

 Goods and services are the objects that people value and
produce to satisfy human wants. What we produce changes
over time. Only goods that will survive are those wanted by
consumers (consumer interest)

 How is this determined in a market economy? Consumers

drive market/production; free market capitalism vs command
allocation system
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2. How to Produce?

 Goods and services are produced using the factors of

production (land, labor, capital, and entrepreneurship).

 How is this determined in a market economy? Sellers, cost of

production, income, etc.

3. For Whom to Produce?

 Land earns rent, labor earns wages, capital earns interest, and
entrepreneurship earns profit.

 How is this determined in a market economy? Income

distribution, buyers need desire for a product & income to buy

B. When is the pursuit of self-interest in the social interest?

 People make choices in their self-interest. Spending = funds

companies = production

 Choices that are the best for society as a whole are said to be in
the social interest.

When people pursue their own self-interest,

__is it possible that these choices are also in the social interest__?

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We can examine whether the self-interested choices serve the social
interest for a variety topics. For example,

 Privatization: Fall of socialism in Europe

 Globalization: Local impact of expanding of international trade
 “New” Economy: Technological revolution forces change
 Corporate Scandals
 HIV/AIDS: Poorest countries worst hit, lack available drugs
 Disappearing Tropical Rainforests: A lack of property rights
 Water shortages: Consumers fail to pay for opportunity costs
 Unemployment
 Deficits and Debts: Future generations pay for today’s services

Below are institutions essential in an economy to align self-interest

in a way that economic activity will lead to the social interest.

 Property Rights that are enforced by a system of laws property

rights = incentives to buy goods

 A dependable and non-corrupt Legal System

 A stable political system with a non-corrupt government lack of

stable political system leads to coup

 Competitive and Open Markets that enable voluntary exchange

leads to greater economic benefit

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 Economic Way of Thinking 8/30/2016

Scarcity requires choices and choices create tradeoffs.

A __tradeoff___ is an exchange—giving up one thing to get another.

The answers to the fundamental questions of economics all involve
tradeoffs. There will always be tradeoffs. For example,

 Government redistribution of income plays a role in answering “for

whom” goods and services are produced, but redistribution
confronts society with the tradeoff between equity and efficiency.

Taxing productive workers lessens their incentives to work and

transferring funds to low income people blunts their incentives to
work. On both counts, fewer goods and services are produced.
Income effect: work more if you make less $/hr, work less if more

Seeing choices as tradeoffs shows there is an opportunity cost of a

choice.

 Opportunity Cost is the best alternative sacrificed for a chosen

alternative. i.e. sleeping instead of coming to class

Marginal Analysis is an examination of the effects of additions to or

subtractions from a current situation. (subconscious) weighing of options
 Choosing at the Margin or making choices at the margin means
looking at the trade-offs that arise from making small changes
in an activity.

 People make choices at the margin by comparing the benefit

from a small change in an activity (which is the marginal
benefit) to the cost of making a small change in an activity
(which is the marginal cost).
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Responding to Incentives
 Changes in marginal benefits and marginal costs alter the
incentives that we face when making choices. When incentives
change, people’s decisions change. incentives play role in the
decision to repeat a certain choice

Economics is a Social Science that follows a standard scientific

method.

The Scientific method is a step-by-step procedure for solving

problems. The steps are first making observations and measurements,
second building a model, and third testing the model to see if the data
is consistent with theory. Same as scientific method in natural sciences

An economic model describes some aspect of the economic world that

includes only those features needed for the purpose at hand. Economic
models should support economic theory

 Economic models describe the economic world in the same

way that a road map explains the road system: Both of these
focuses on only what is important and both are abstract
depictions of the real world. Driving to Chicago = no need to
know the history of the streets/buildings on the way

An economic theory is a generalization that summarizes what we

think we understand about the economic choices that people make and
the performance of industries and entire economies.
 It is the ______bridge between the economic model and the real
economy______.

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Economists distinguish between positive statements and normative statements.

A positive statement is about “what is or how something works” and is testable.

For example,

 “If the ___national unemployment rate rises to 7 percent. Then

teenage unemployment will exceed 80 percent___.”

A normative statement is about “what ought to be” and is an opinion

and so is inherently not testable. It does not suggest a definitive
testable idea of how something works. For example,

 “The tax _____on a gallon of gasoline should be raised____.”

In the following quotes identify the positive and the normative

statements.

A. "In 1938 Congress enacted. . ." positive statement

B. "Today a minimum wage worker. . . deplorable annual increase."

Normative statement

C. "Only a small percentage. . . are full-time workers below the

poverty line." Positive statement

D. "They say it is outrageous that a worker can work full-time and. . ."
normative statement

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E. There are several obstacles that can affect economic analysis

The Ceteris Paribus Assumption means that while certain variables change,
“all other things remain unchanged.” Variable that change = dependent
variable, just as important as independent variables (that don’t change):
income, prices of related goods, preferences, etc.

 A theory cannot be tested legitimately unless its ceteris paribus assumption

is satisfied.

Unscrambling Cause and Effect: The post hoc fallacy is the error of reasoning
that a first event causes a second event because the first event occurred before
the second. i.e. bringing umbrella to class, then it rains

 Association (correlation) versus Causation: The fact that one event follows
another does not necessarily mean that the first event caused the second
event. Bringing umbrella did not cause it to rain; economists never say direct
causation, just that studies/results are consistent with…
The fallacy of composition is a (false) statement that what is true for
the parts is also true for the whole, or what is true for the whole is also
true for the parts. Comes up in many economic settings