Chapter 1
The Nature
of Economics
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Today, the U.S. government is part owner of some
major U.S. banks.
What greater government control means for decision
making about what and how much to produce, how to
organize production, and who obtains the items
produced?
You will learn the answer to this question in this
chapter.
Learning Objectives
• Discuss the difference between
microeconomics and macroeconomics
• Evaluate the role that rational self-interest
plays in economic analysis
• Explain why the study of economics
is a science
• Distinguish between positive and normative
economics
Chapter Outline
• The Power of Economic Analysis
• Defining Economics
• The Three Basic Economic Questions and Two
Opposing Answers
• The Economic Approach: Systematic Decisions
• Economics as a Science
• Positive versus Normative Economics
Did You Know That ...
• Economics is one of the fastest-growing
college majors?
• During the past 10 years, the number of
students majoring in economics at U.S.
colleges has increased by 40%?
• Economics majors typically land higher paying
jobs than other majors?
The Power of Economic Analysis
• Incentives
– Rewards for engaging in a particular activity
– The nature of individuals’ self-interested
responses to incentives is the starting point for
economic analysis
The Power of Economic
Analysis (cont'd)
• The economic way of thinking is a framework
to analyze solutions to economic problems.
– How much time to study
– Choosing which courses to take
– Whether the U.S. government should encourage
or discourage immigration
The Power of Economic
Analysis (cont'd)
• The economic way of thinking gives you the
power—the power to reach informed
conclusions about what is happening in the
world.
• Economic analysis helps you make better
decisions, and increases your understanding
when watching or reading the news on the
Web.
The Power of Economic
Analysis (cont'd)
• Economic analysis is a way of thinking about
all decisions.
– Your education, career, financing your home,
family
– Your involvement in the business world, or in
politics as a voter
Defining Economics
• Economics
– The study of how people allocate their limited
resources to satisfy their unlimited wants
– The study of how people make choices
Defining Economics (cont'd)
• Resources
– Things used to produce other things to satisfy
people’s wants
• Wants
– What people would buy if their incomes were
unlimited
Defining Economics (cont'd)
• With limited income (resources), people must
make choices to satisfy their wants.
• We never have enough of everything,
including time, to satisfy our every desire.
Defining Economics (cont'd)
• Individuals, businesses, and nations face
alternatives, and choices must be made.
• Economics studies how these choices are
made.
Microeconomics
versus Macroeconomics
• Microeconomics
– The study of decision making undertaken by
individuals (or households) and by firms
– Like looking though a microscope to focus on the
smaller parts of the economy
• The effects of changes in gasoline prices
• A family’s choice of having a baby
• An individual firm’s decision to advertise
Microeconomics
versus Macroeconomics (cont'd)
• Macroeconomics
– The study of the behavior of the economy as a
whole
– Deals with economywide phenomena
• The national unemployment rate
• The rate of inflation
• The yearly output of goods and services in a nation
Microeconomics
versus Macroeconomics (cont'd)
• Macroeconomics deals with aggregates, or
totals—such as total output in an economy.
• Modern economic theory blends micro and
macro concepts.
The Three Basic Economic Questions and Two Opposing
Answers
• Economic System
– The institutional mechanism through which
resources are utilized to satisfy human wants
The Three Basic Economic Questions and Two Opposing
Answers (cont’d)
• Three economic questions:
1. What and how much will be produced?
2. How will items be produced?
3. For whom will items be produced?
The Three Basic Economic Questions and Two Opposing
Answers (cont’d)
• Two opposing answers in the form of
economic systems:
– Centralized command and control (central
planning): Authority that makes all economic
decisions
– Price system (market system): Decentralized
decision making process in which prices are
terms (signals) under which people agree to
make exchanges
The Three Basic Economic Questions and Two Opposing
Answers (cont’d)
• Economic systems of the world’s nations
(e.g., U.S.) are mixed systems that
incorporate aspects of both centralized
command and control and a decentralized
price system
The Economic Approach:
Systematic Decisions
• Economists assume that individuals act as if
motivated by self-interest and respond
predictably to opportunities for gain.
The Economic Approach:
Systematic Decisions (cont’d)
“It is not from the benevolence of the butcher,
the brewer, or the baker that we expect our
dinner, but from their regard to their own
interest.”
—Adam Smith, An Inquiry into the Nature and
Causes of the Wealth of Nations, 1776
International Example: Indian Men Living in the United States
Become Ineligible Bachelors
• For Indian men working in the United States, finding a bride
back in India has become more difficult.
• Today an increasing number of Indian women opt for married
life in India, where jobs are plentiful, instead of marrying to a
man in the United States, where the unemployment rate has
exceeded 10 percent.
The Economic Approach:
Systematic Decisions (cont’d)
• Rationality Assumption
– The assumption that people do not intentionally
make decisions that would leave them worse off
The Economic Approach:
Systematic Decisions (cont’d)
• Questions
– Does the fact that some people make apparently
irrational choices invalidate the rationality
assumption in economics?
– Can economic models be applied to situations in
which behavior is at odds with what we expect
from rational people?
The Economic Approach:
Systematic Decisions (cont’d)
• Responding to incentives
– Rationality and the use of incentives
• Positive incentives
• Negative incentives
– Making choices
• Balancing cost and benefits
The Economic Approach:
Systematic Decisions (cont’d)
• Some examples of incentives
– Responding to positive incentives
• Schoolchildren getting gold stars, working to have a
“better life” for yourself
– Responding to negative incentives
• Penalties, punishments, using credit cards to avoid
check overdrafts
Policy Example: The Government Gives Everyone an Incentive to
Own a Golf Cart
• The U.S. government and some state governments offer tax
credits to people buying electric vehicles, including golf carts.
• Golf carts sales have soared as many people have found that
these tax credits were sufficient to fund more than two-thirds
of the price of a qualifying golf cart.
The Economic Approach:
Systematic Decisions (cont’d)
• Defining self-interest
– The pursuit of one’s goals, does not always mean
increasing one’s wealth
• Prestige
• Friendship
• Love
Example: The Perceived Value of Gifts
• Often the recipient of the gift places a value
on it far less than the market value.
• Should we substitute gift certificates for
physical gifts?
Economics as a Science (cont’d)
• Economics is a social science that employs the
same kinds of methods used in other sciences,
such as biology.
• Economics uses models.
Economics as a Science
• Models or Theories
– Simplified representations of the real world used
as the basis for predictions or explanations
– Should capture only the essential relationships
that are sufficient to analyze a problem
– Cannot be faulted as unrealistic simply because it
does not represent every detail of the real world
• A map is the quintessential model
Economics as a Science (cont'd)
• Assumptions
– The set of circumstances in which a model is
applicable
– Every model, or theory, must be based on a set of
assumptions.
Example: Getting Directions
• A map is a simplifying model of reality.
• The degree of simplification varies across maps; some contain
more detail than others.
• Economic models attempt to focus on what is relevant to the
problem at hand and omit what is not.
Economics as a Science (cont'd)
• Ceteris Paribus Assumption
[KAY-ter-us PEAR-uh-bus]
– Nothing changes except the factor or factors being
studied.
– “Other things constant”
– “Other things equal”
Economics as a Science (cont'd)
• Economics is an empirical science.
– Real-world data is used to evaluate the usefulness
of a model.
– Models are useful if they predict economic
phenomena.
– Economic models predict how people react, not
how they think.
Economics as a Science (cont'd)
• Behavioral Economics
– Approach to the study of consumer behavior
• Emphasizes psychological limitations and complications
which may interfere with rational decision making
– Proponents believe that it is “unrealistic” to
assume:
• Unbounded selfishness
• Unbounded willpower
• Unbounded rationality
Economics as a Science (cont'd)
• Bounded Rationality
– Hypothesis that people are nearly, not fully,
rational
• They cannot examine every choice available to them
• They appear to use rules of thumb to sort alternatives
Why Not … try to increase blood donations by offering small
payments to donors?
• To encourage more people to give blood, some governments
now provide small payments to blood donors.
• But some people who have previously donated blood may
become less likely to respond to blood drives because they
believe the financial payments might make them look
“greedy” by selling blood instead of making a sacrifice.
Positive versus
Normative Economics
• Positive Economics
– Purely descriptive statements or scientific
predictions; “If A, then B,” a statement of what is
• Normative Economics
– Analysis involving value judgments; relates to
whether things are good or bad, a statement of
what ought to be
You Are There: A Movie Producer Responds to Incentives
• Initially, movie producer Ingo Volkammer planned to film the
action movie Velocity in North America.
• Later the Spanish and German governments offered him
subsidies to cover much of the firm’s production cost.
• But still later changes in the euro’s value raised the dollardenominated cost of filming in Europe, so that Volkammer
eventually returned the climactic scenes to North America.
Issues & Applications: In Many U.S. Industries, Command and
Control Rules
• In 2008, the U.S. government required a number of U.S. banks
to accept taxpayer-funded purchases of ownership shares in
those banks.
• Even though banks, including JPMorgan Chase and Bank of
America, have bought back the government’s shares, the
government will likely remain a large shareholders at
Citigroup and some other major banks.
• In 2009 and 2010, government command and control also
spread to the auto and health care industries.
Figure 1-1 Banks Receiving the Largest Amounts of U.S.
Government Funding
Summary Discussion
of Learning Objectives
• Microeconomics versus macroeconomics
– Economics is the study of how individuals make
choices to satisfy wants
– Microeconomics is the study of decision making
by individual households and individual firms
– Macroeconomics is the study of nationwide
phenomena, such as inflation and unemployment
levels
Summary Discussion
of Learning Objectives (cont'd)
• Self-interest in economic analysis
– Rational self-interest is the assumption that
individuals behave in a reasonable (rational) way
in making choices to further their interests
Summary Discussion
of Learning Objectives (cont'd)
• Economics as a science
– Economists use models, or theories, that are
simplified representations of the real world to
analyze and make predictions about the real world
Summary Discussion
of Learning Objectives (cont'd)
• The difference between positive and
normative economics
– Positive economics deals with what is, whereas
normative economics deals with what ought to be
– Positive statements are of the “if…then” variety,
while normative ask what “should, or could” be
Appendix A: Reading and Working with Graphs
• Independent Variable
– A variable whose value is determined independently of, or outside, the
equation under study
• Dependent Variable
– A variable whose value changes according to changes in the value of
one or more independent variable
Appendix A: Direct and Inverse Relationship
• Direct Relationship
– A relationship between two variables that is positive, meaning that an
increase in one variable is associated with an increase in the other and
a decrease in one variable is associated with a decrease in the other
• Inverse Relationship
– A relationship between two variables that is negative, meaning that an
increase in one variable is associated with a decrease in the other and
a decrease in one variable is associated with an increase in the other
Table A-1 Gas Mileage as a Function of Driving Speed
Figure A-1 Direct and Inverse Relationships
Appendix A: Constructing a Graph
• Number Line
– A line that can be divided into segments of equal length, each
associated with a number
• y Axis
– The vertical axis in a graph
• x Axis
– The horizontal axis in a graph
• Origin
– The intersection of the y axis and the x axis in a graph
Figure A-2 Horizontal Number Line
Figure A-3 Vertical
Number Line
Figure A-4 A Set of Coordinate Axes
Table A-2 T-Shirts Purchased
Figure A-5 Graphing the Relationship Between T-Shirts
Purchased and Price
Figure A-6 Connecting the Observation Points
Figure A-7 A Positively Sloped Curve
Appendix A: The Slope of a Line (A Linear Curve)
• Slope
– The change in the y value divided by the corresponding change in the x
value of a curve
– The “incline” of the curve
– “Rise” over “run”
Figure A-8 Figuring Positive Slope
Figure A-9 Figuring Negative Slope
Figure A-10 The Slope of a Nonlinear Curve