Chapter 1 notes

Definition of Economics

The first thing that we should discuss is the definition of "economics." Economists generally
define economics as the study of how individuals and societies use limited resources to satisfy
unlimited wants. To see how this concept works, think about your own situation. Do you have
enough time available for everything that you wish to do? Can you afford every item that you
would like to own? Economists argue that virtually everyone wants more of something. Even the
wealthiest individuals in society do not seem to be exempt from this phenomenon.

This problem of limited resources and unlimited wants also applies to society as a whole. Can
you think of any societies in which all wants are satisfied? Most societies would prefer to have
better health care, higher quality education, less poverty, a cleaner environment, etc.
Unfortunately, there are not enough resources available to satisfy all of these goals.

Thus, economists argue that the fundamental economic problem is scarcity. Since there are not
enough resources available to satisfy everyone’s wants, individuals and societies have to choose
among available alternatives. An alternative, and equivalent, definition of economics is that
economics is the study of how such choices are made.

Economic Goods, Free Goods, and Economic Bads

A good is said to be an economic good (also known as a scarce good) if the quantity of the good
demanded exceeds the quantity supplied at a zero price. In other words, a good is an economic
good if people want more of it than would be available if the good were available for free.

A good is said to be a free good if the quantity of the good supplied exceeds the quantity
demanded at a zero price. In other words, a good is a free good if there is more than enough
available for everyone even when the good is free. Economists argue that there are relatively
few, if any, free goods.

An item is said to be an economic bad if people are willing to pay to avoid the item. Examples of
economic bads include things like garbage, pollution, and illness.

Goods that are used to produce other goods or services are called economic resources (and are
also known as inputs or factors of production). These resources are often categorized into the
following groups:

1. Land,
2. Labor,
3. Capital, and
4. Entrepreneurial ability.
The category of "land" includes all natural resources. These natural resources include the land
itself, as well as any minerals, oil deposits, timber, or water that exists on or below the ground.
This category is sometimes described as including only the "free gifts of nature," those resources
that exist independent of human action.

The labor input consists of the physical and intellectual services provided by human beings. The
resource called "capital" consists of the machinery and equipment used to produce output. Note
that the use of the term "capital" differs from the everyday use of this term. Stocks, bonds, and
other financial assets are not capital under this definition of the term.

Entrepreneurial ability refers to the ability to organize production and bear risks. Your text does
not list this as a separate resource, but instead considers it as a type of labor input. Most other
introductory texts, though, list this as a separate resource. (No, your text is not wrong, it just uses
a different way of classifying resources. I think it's better, though, to stick with the somewhat
more standard classification in this course.)

The resource payment associated with each resource is listed in the table below:

Economic Resource Resource Payment

land rent

labor wages

capital interest

entrepreneurial ability    profit

Rational Self-interest

As noted above, scarcity results in the need to choose among competing alternatives. Economists
argue that individuals pursue their rational self-interest when making choices. This means that
individuals are assumed to select the alternative(s) that they believe will make them happiest,
given the information that they possess at the time of the decision.

Note that the term "self-interest" means something quite different than "selfish." Self-interested
people may donate their time to charitable organizations, give gifts to loved ones, contribute to
charities and engage in other similarly altruistic activities. Economists assume, though, that
altruistic people select these actions because they find these activities more enjoyable than
available alternative activities.

Economic Methodology

Economic discussions may involve both positive and normative analysis. Positive analysis
involves attempts to describe how the economy functions. Normative economics relies on value
judgments to evaluate or recommend alternative policies.
As a social science, economics attempts to rely on the scientific method. The scientific method
consists of the following steps:

1. Observe a phenomenon,
2. Make simplifying assumptions and develop a model (a set of one or more hypotheses),
3. Make predictions, and
4. Test the model.

If the model is rejected in step 4, formulate a new model. If the test fails to reject the model,
conduct additional tests.

Note that tests of a model can never prove that a model is true. A single test, however, may be
used to establish that a model is incorrect.

Economists rely on the ceteris paribus assumption in constructing models. This assumption,
translated roughly as "other things constant," allows economists to simplify reality so that it may
be more readily understood.

Logical fallacies

The fallacy of composition occurs when one incorrectly attempts to generalize from a
relationship that is true for each individual, but is not true for the whole group. As an example of
this, note that any person can get a better view at a concert by standing (regardless of the actions
of those in from of him or her). It is incorrect, though, to state that everyone can get a better view
if everyone stands.

Similarly, one would commit the fallacy of composition if one were to claim that, since anyone
could increase his or her wealth by stealing from his or her neighbors (assuming no detection),
that everyone can become wealthier if everyone steals from their neighbors.

The association as causation fallacy, also known less technically as the post hoc, ergo propter
hoc fallacy, occurs if one incorrectly assumes that one event is the cause of another simply
because it precedes the other event. The Super Bowl example discussed in your text is a good
example of this logical fallacy.

Microeconomics vs. Macroeconomics

Microeconomics involves the study of individual economic agents and individual markets.
Macroeconomics involves the study of economic aggregates.

Alegbra and Graphical Analysis in Economics

(This is a summary of some of the most important material in the appendix to Chapter 1.) Graphs
are extensively used in economic analysis to represent the relationships that exist among
economic variables. Two simple types of relationships that may exist are direct and inverse
relationships.

A direct relationship is said to exist between two variables X and Y if an increase in X is

always associated with an increase in Y and a decrease in X is associated with a decrease in Y. A
graph of such a relationship will be upward sloping, as in the diagram below.

A direct relationship may be linear (as in the diagram above), or it may be nonlinear (as in the
diagrams below).

An inverse relationship is said to exist between the variables X and Y if an increase in X is

always associated with a decrease in Y and a decrease in X is associated with an increase in Y. A
graph of an inverse relationship will be downward sloping.
An inverse relationship may also be either linear or nonlinear (as illustrated below).

A linear relationship possesses a constant slope, defined as:

If an equation can be written in the form: Y = mX + b, then:

m = slope, and

b = y-intercept.