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Economics and Economic Reasoning

Chapter 1

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Laugher Curve
Q. Why did God create economists?  A. In order to make weather forecasters look good. 

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What Economics Is 

Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society.

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What Economics Is 

One of the key words in the definition is ³coordination.´

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What Economics Is 

Any economic system must solve three central coordination problems:
What, and how much, to produce.  How to produce it.  For whom to produce it. 

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What Economics Is 

Scarcity exists because individuals want more than can be produced. 

Scarcity ² the goods available are too few to satisfy individuals· desires.

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What Economics Is 

The degree of scarcity is constantly changing.  The quantity of goods, services, and usable resources depends on technology and human action.

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What Economics Is 

Economics is the study of how to get people to do things they're not wild about doing and not to do things they are wild about doing.

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What Economics Is 

To understand the economy, you need to learn:
Economic reasoning.  Economic terminology.  Economic insights economists have about issues, and theories that lead to those insights. 

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What Economics Is 

To understand the economy, you need to learn: 

Information about economic institutions.  Information about the economic policy options facing society today.

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A Guide to Economic Reasoning 

Economic reasoning is making decisions by comparing costs and benefits.

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Marginal Costs and Marginal Benefits 

The relevant costs and benefits that matter are the expected incremental, or additional, costs incurred and the expected incremental benefits of a decision.

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Marginal Costs and Marginal Benefits 

Economist use the term marginal when referring to additional or incremental.

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Marginal Costs and Marginal Benefits 

Marginal cost ± the additional cost to you over and above the costs you have already incurred. 

This means not counting sunk costs ² costs that have already been incurred and cannot be recovered.

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Marginal Costs and Marginal Benefits 

Marginal benefit ± the additional benefit above and beyond what you¶ve already accrued.

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Marginal Costs and Marginal Benefits 

According to the economics decision rule:
If the relevant benefits of doing something exceed the relevant costs, do it.  If the relevant costs of doing something exceed the relevant benefits, don·t do it. 

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Economics and Passion
Economic reasoning is based on the premise that everything has a cost.  It leads to a better society for the majority of people. 

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Opportunity Cost
Opportunity cost is the basis of cost/benefit economic reasoning  It is the benefit foregone, or cost, of the next-best alternative to the activity you have chosen. 

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Opportunity Cost 

In economic reasoning, opportunity cost must be less than the benefit of what you have chosen.

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Opportunity Cost 

Opportunity costs are not limited to individual decisions but to government decisions as well.

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Economics and Market Forces
The opportunity cost concept applies to all aspects of life.  It is fundamental to understanding how society reacts to scarcity. 

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Economics and Market Forces 

When goods are scarce, they must be rationed. 

That means a mechanism must be chosen to determine who gets what.

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Economics and Market Forces 

Economic forces are the necessary reactions to scarcity.

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Economics and Market Forces 

A market force is an economic circumstance that is given relatively free rein by society to work through the market.

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Economics and Market Forces 

Market forces ration by changing prices.  When there is a shortage, the price goes up.  When there is a surplus, the price goes down.

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Economics and Market Forces 

Economic reality is controlled by three forces:
Economic forces (the invisible hand).  Social and cultural forces.  Political and legal forces. 

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Economics and Market Forces 

The invisible hand is the price mechanism, the rise and fall of prices, that guides our actions in a market.

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Economics and Market Forces 

Social, cultural, and political forces play a major role in deciding whether to allow market forces to predominate.

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Economics and Market Forces 

Political and social forces often work together against the invisible hand.  Social and political forces are active in all parts of your life.

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Economics and Market Forces 

What happens in society can be seen as a reaction to, and interaction of, economic forces, political forces, social forces, and historical forces.

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Economic Terminology
You¶ll need to learn economic terminology.  Hundreds of economic terms will be introduced in this book. 

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Economic Insights 

General insights into how economies work are often based on generalizations called economic theories.

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Economic Insights 

Theory ties together economists¶ terminology and knowledge about economic institutions and leads to economic insights.

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Economic Insights 

Economic theories are too abstract to apply to specific cases. 

A theory is often embodied in an economic model or an economic principle.

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Economic Insights 

Economic model ± a framework that places the generalized insights of the theory in a more specific contextual setting.

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Economic Insights 

Economic principle ± a commonly held insight stated as a law or general assumption.

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Economic Insights 

Economists cannot test their models with controlled experiments.  It is impossible to hold ³other things constant,´ as is done in laboratory experiments.

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Economic Insights 

Theories, models, and principles must be combined with a knowledge of real-world economic institutions to arrive at a specific policy recommendation.

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The Invisible Hand Theory 

Economist have come to the following insight:
Price has a tendency to fall when the quantity supplied is greater than the quantity demanded.  Price has a tendency to rise when the quantity demanded is greater than the quantity supplied. 

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The Invisible Hand Theory 

According to the invisible hand theory, a market economy, through the price mechanism, will allocate resources efficiently.  Efficiency means achieving a goal as cheaply as possible.

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Economic Theory and Stories
Economic theory and its models are a shorthand means of telling a story.  If you can¶t translate a theory into a story, you don¶t understand the theory. 

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Microeconomics and Macroeconomics 

Economic theory is divided into two parts: microeconomic theory and macroeconomic theory.

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Microeconomics 

Microeconomics is the study of individual choice, and how that choice is influenced by economic forces.

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Microeconomics 

Microeconomics studies such things as:
The pricing policy of firms.  Households· decisions on what to buy.  How markets allocate resources among alternative ends. 

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Macroeconomics
Macroeconomics is the study of the economy as a whole.  It considers the problems of inflation, unemployment, business cycles, and economic growth. 

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Economic Institutions 

To apply economic theory to reality, you¶ve got to have a sense of economic institutions. 

Economic institutions ² laws, common practices, and organizations in a society that affect the economy.

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Economic Institutions 

Economic institutions differ significantly among nations.  They sometimes seem to operate in ways quite different than economic theory predicts.

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Economic Policy Options 

Economic policies are actions (or inactions) taken by government to influence economic actions.

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Economic Policy Options 

To carry out economic policy effectively, one must understand how the economic policy might change institutions.

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Objective Policy Analysis
Good objective policy analysis keeps the value judgments separate from the analysis.  Subjective policy analysis is that which reflects the analyst¶s view of how things should be. 

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Objective Policy Analysis 

To make clear the distinction between objective and subjective analysis, economics is divided into three categories:
Positive economics  Normative economics  Art of economics 

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Objective Policy Analysis 

Positive economics ± the study of what is, and how the economy works.  Normative economics ± the study of what the goals of the economy should be.

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Objective Policy Analysis 

Art of economics ± the application of the knowledge learned in positive economics to achieve the goals determined in normative economics.

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Objective Policy Analysis 

Maintaining objectivity is easier in positive economics ± harder in normative economics.

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Objective Policy Analysis 

It is hardest to maintain objectivity in the art of economics.  It embodies the problems of both positive and normative economics

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Policy and Social and Political Forces
The choice of policy options depends on more than economic theory.  As soon as economists apply economy theory to policy, political and social forces must be taken into account. 

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Economics and Economic Reasoning

End of Chapter 1

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