Overview
The Economic Way of Thinking
The Theory of Economics does not furnish a
body of settled conclusions immediately
applicable to policy. It is a method rather than a
doctrine, an apparatus of mind, a technique of
thinking which helps its possessor to draw
correct conclusions.
--John Maynard Keynes
The essence of economics
• Voluntary trade can create wealth
• Specialization and exchange promote
economic growth
• Market prices signal relative scarcities and
coordinates the allocation of resources
• Perfectly competitive markets are efficient
Voluntary trade can create wealth!
• Wealth is whatever people value.
• Value is in the eyes of the chooser.
• Both traders increase their own wealth
by cooperating in an exchange.
Voluntary trade can create wealth!
Jack has an apple. He is willing to pay $1 for an
apple, and $2 for a pear.
Rose has a pear. She is willing to pay $1 for a
pear, and $2 for an apple.
Both of them are willing to trade with the other.
Before trade, the total wealth is $2.
After trade, the total wealth is $4.
Voluntary trade can create wealth!
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Where does the additional wealth come from?
Trade is a productive process.
Production is trying to add value to the input.
Jack uses an apple as input and obtains a pear
as output
• Rose uses a pear as input and obtains an apple
as output
Voluntary trade can create wealth!
• Economics growth consists not in increasing
the production of things, but in increasing the
production of wealth.
• Trade is a process of creating wealth.
Voluntary trade can create wealth!
• Hence
Voluntary exchange can benefit both parties.
• If not, then neither party would participate in
the trade in the first place!
Social Exchange can create wealth!
• This conclusion can be extended to social
exchange, which gives rise to a famous theory
in sociology –– social exchange theory.
• In a word, social exchange theory claims that,
your decision to engage in social interactions
with other people indicates that you can
benefit from it (emotionally, mentally,
spiritually, etc.) Otherwise, you would not
engage in it in the first place!
Specialization can promote economic growth!
• Specialization = pursuit of one’s comparative
advantage
• Specialization can expand production
possibilities (wealth) by trading for something
that is more costly to produce on their own
• Recall that economic growth is represented by
the expansion of production possibilities
Specialization can promote economic growth!
Specialization can promote economic growth!
Specialization can promote economic growth!
PPFs without specialization and trade
Specialization can promote economic growth!
Suppose both specialize
Exchange of 3 Lager for 3 stout
Specialization can promote economic growth!
Each enjoys a combination that lies beyond original
frontiers
Specialization can promote economic growth!
• People expect to enjoy greater wealth by
specializing in activities in which they believe
themselves to have a comparative advantage
• We often ask questions about our
comparative advantages
– “What major is best for me?”
– “What opportunities will I enjoy after I graduate?”
The Role of Market Prices
• The market is where supply meets demand
• Scarcity is a relationship between desirability
and availability, or between demand and
supply
• Market prices inform us of relative scarcities.
• Prices convey useful information that
coordinates the allocation of resources
The Role of Market Prices
• In other words, price is the signal that helps
people to determine their comparative
advantages
– Entrepreneurs use prices to determine what to
produce
– Employees use wages to determine what job they
will take
The Role of Market Prices
• When price is higher than it is supposed to be
(higher than the equilibrium price), a surplus
occurs.
• A surplus informs the sellers that the
production is overvalued
• They will cut off production and reallocate
resources elsewhere.
The Role of Market Prices
• When price is lower than it is supposed to be
(lower than the equilibrium price), a shortage
occurs.
• A shortage informs the sellers that the
production is undervalued
• They will reallocate resources from elsewhere
and increase the production.
The Role of Market Prices
• Question: What happens to current price if
some people know the price to increase in the
future?
The Role of Market Prices
• Answer: Expectation of a rise in price will increase
the demand and decrease the supply. A change in
expectations about tomorrow’s price can alter
today’s price (self-fulfilling prophecy)
• A rise in current price will help the consumers
and producers (even those without the
information that the price will rise in the future)
to reallocate resources and hence prepare for the
future.
The Role of Market Prices
Pakistan just had a bad harvest in wheat. Out of
the goodness of our good heats, we want to
help them.
Question: Do you think it is wise to help them by
sending them wheat?
The Role of Market Prices
• Answer: If we send them wheat, it will
distort/depress the price of wheat in their
domestic market.
• In the long run, this will prevent resources to
be allocated for wheat production in Pakistan.
• It is better to help them with money, with
which they can buy wheat either from US
market or domestic market.
Perfectly Competitive Markets
• Economically efficient  the additional
benefits outweigh the additional costs
• Perfectly competitive market is efficient (total
surplus is maximized).
Ask the Right Questions
Three guys go to a motel and get a room. The
total charge is $30, and each guy pays $10.
After they go to their room, the desk clerk
realizes he over charged them. He forgot
about the special rate of $25 tonight. The
clerk can’t leave his desk, so he contacts the
maid, gives her five $1 bills, and asks her to go
to the room and reimburse the three guys.
Ask the Right Questions
On her way, the maid wonders how she can
divide $5 among three people. She decides,
since they aren’t aware of the overcharge
anyway, to give them $3 back and secretly
pocket the remaining $2. No one will be any
the wiser.
Ask the Right Questions
Now for the brainteaser:
Each guy paid, in effect, $9: 3 times 9 equals
27. And the maid pocketed $2, for a total of
$29. But the three guys originally paid $30,
not $29.
Where did the other dollar go?
Ask the Right Questions
• It is nonsensical to ask “Where did the other
dollar go?” because there is no answer to that
question
• The right question “Where did the rest of the
overpayment go?”
• Economics gives you with the ability to see
through the nonsense.
Ask the Right Questions
• When evaluating an economic policy, we should
pay more attention to the unintended
consequences, instead of the motives
• What are the motives?
• Think outside the box. Don’t get confused by
the motives
• What are the unintended consequences?
Unintended Consequences
• We cannot assume people behave the same
way facing in a new situation
• Enforcement of a policy changes people’s
incentives, which results in unintended
consequences that are not expected by the
policy-makers
Rent control: Goal
• Make sure low-income people may get cheap
rent
• Reduce their living expenses
Rent control: Unintended Consequences
• Lots of people cannot find an apartment to live.
People resort to other ways to compete for
available apartments (long lines, reading
obituary, bribery, etc.)
• Landlords have little incentive to maintain
quality. Landlords will discriminate using nonprice criteria
• The low price cannot attract people to construct
new rental units
Rent control: Let the market work
• When the price is allowed to fluctuate,
increased price will attract resources to be used
to build new rental units to be built
Agricultural Price Support: Goal
• Protect family farmers
• Without the price support, family farmers will
be driven out of market due to economic losses
caused by high production cost
Agricultural Price Support
Unintended consequences
• Create economic profits for corporate farms
with lower production costs
• Profits attract outsiders to bid for farmland and
increase the price of farmland
• Higher cost of land increases production cost
– For owners of farmland, economic losses is
mitigated by the greater implicit value of their land;
– For many farm families who rent their land, there is
no such compensation
Agricultural Price Support
Let the Market Work
• The market price should have informed the
family farmers to reallocate resources where
they are more highly valued
Minimum Wage
• Goal: protect unskilled workers
• Unintended consequences: Unemployment.
Especially for those with low skills.
Unintended Consequences
• Economics was christened “the dismal science”
because its analysis frustrated so many hope
and desires.
• On the other hand, knowing what is not
possible can spare us many disappointments
and avoid many disasters.
The Role of Government
• Competitive markets are efficiency, so the
government should keep economic intervention
minimal for competitive market
• Then, what is the role of government?
Three conditions for economic efficiency
• Large numbers of buyers and sellers; no one
party has the ability to manipulate the market
(counterexample: monopoly)
• No externalities (counterexamples: pollution,
education, public goods, common resources)
• Complete information available about the
quality of the goods (counterexample: used car)
The Role of Government
• Government does have a role to play in the
economic system
• E.g. protecting property rights, regulating
monopoly and promoting competition, taxing
pollution, subsidizing education, providing
public goods, regulating the use of common
resources, protecting the poor
• But controlling the market prices should be
cautioned
Is Market Economy Perfect?
• Market economy is not perfect or all-wise
• There are a lot of problems with this economic
system (e.g. inequality)
• It is a mistake to contrast a less-than-ideal
situation with an ideal-but-unattainable
situation.
Is Market Economy Perfect?
• Democracy is the worst form of government
except all those other forms that have been
tried from time to time. —Winston Churchill
• Market economy is the worst form of economic
system except all those other forms that have
been tried from to time.
Want to know more about economics?
• One of the best
economic textbooks
• Insightful book with
storytelling
• No complicated
technical analysis or
graphs
Want to know more about economics?
• Which is more
dangerous, a gun or a
swimming pool? A
shark or a football?
• What do school
teachers and sumo
wrestlers have in
common?
• How incentives work?
Want to know more about economics?
• Why do the keypads on
drive-up cash machines
have Braille dots?
• Why are round-trip
fares from Orlando to
Kansas City higher than
those from Kansas City
to Orlando?
• Cost-benefit analysis
Are people really rational?
• Behavioral Economics
• How people really
make decisions?
• We will see from the
book that people often
make irrational
decisions.
Beyond Economics:
Can economics make
you happy?
Beyond Economics:
Can economics make me happy?
• Economics investigates the allocation of
scare resources
• It assumes available resources cannot
satisfy wants, and there is always a tension
between availability and desirability
Beyond Economics:
Can economics make me happy?
• Happiness is getting what you want.
• According to economics, people can never
satisfy, so we can never be happy…
• But…
• Wealth is whatever people value.
• Value is in the eyes of the chooser.
Beyond Economics:
Can economics make me happy?
• Buddha wanted nothing—and that’s pretty
much what he got.
• Since he had found what he wanted, he
became wealthy.
• And he was happy.
How to Become Happy?
A word of wisdom…
• Desire everything.
• Need nothing.
• Choose whatever shows up.