WHAT IS
ECONOMICS?
1
CHAPTER
Objectives
After studying this chapter, you will be able to:
 Define economics and distinguish between
microeconomics and macroeconomics
 Explain the three big questions of microeconomics
 Explain the three big questions of macroeconomics
 Explain the ideas that define the economic way of
thinking
 Explain how economists go about their work as social
scientists
Choice, Change, Challenge, and Opportunity
Economics, the science of choice, has much to say about
the change, challenge, and opportunity that we face today.
Technological change, terrorism, and recession provide a
landscape that is rich with problems to be tackled and
choices to be understood.
Your economics course helps you to understand the
powerful forces that shape and change our world.
Definition of Economics
Scarcity
All economic questions arise because we are unable to
satisfy all our wants—because we face scarcity.
Economics is the social science that studies the choices
that individuals, businesses, governments, and societies
make as they cope with scarcity.
Definition of Economics
Microeconomics
Microeconomics is the study of choices made by
individuals and businesses, and the influence of
government on those choices.
Macroeconomics
Macroeconomics is the study of the effects on the
national and global economy of the choices that
individuals, businesses, and governments make.
Three Big Microeconomic Questions
Microeconomics seeks to understand what determines:
 What goods and services are produced
 How goods and services are produced
 For whom goods and services are produced
Goods and services are the objects that people value
and produce to satisfy wants.
Three Big Microeconomic Questions
What Goods and Services
are Produced?
Figure 1.1 shows the
major items produced in
the U.S. economy today.
It emphasizes the
dominant place of services
in our economy.
Three Big Microeconomic Questions
Figure 1.2 shows the
trends in what the U.S.
economy has produced
over the past 60 years.
It shows the decline of
agriculture, mining,
construction, and
manufacturing, and the
expansion of services.
Three Big Microeconomic Questions
The facts about what we
produce raise the deeper
question: What determines
the quantities of realtor
services, new homes, DVD
players, and corn that we
produce?
Microeconomics provides
some answers to these
questions.
Three Big Microeconomic Questions
How are Goods and Services Produced?
Factors of production are the resources that businesses
use to produce goods and services.
They are grouped into four categories:
 Land
 Labor
 Capital
 Entrepreneurship
Three Big Microeconomic Questions
The “gifts of nature” that we use to produce goods and
services are land.
The work time and effort that people devote to producing
goods and services is labor.
The quality of labor depends on human capital, which is
the knowledge and skill that people obtain from education,
on-the-job training, and work experience.
Three Big Microeconomic Questions
The tools, instruments, machines, buildings, and other
constructions that are used to produce goods and services
are capital.
The human resource that organizes land, labor, and
capital is entrepreneurship.
Three Big Microeconomic Questions
Figure 1.3 shows a
measure of the growth of
human capital in the
United States over the last
century—the percentage
of the population that has
completed different levels
of education.
Three Big Microeconomic Questions
The facts about how we
produce raise the deeper
question: What determines
the quantities of capital,
labor, and other resources
that get used to produce
goods and services?
Microeconomics provides
some answers to this
question.
Three Big Microeconomic Questions
For Whom are Goods and Services Produced?
Who gets the goods and services depends on the incomes
that people earn.
 Land earns rent.
 Labor earns wages.
 Capital earns interest.
 Entrepreneurship earns profit.
Three Big Microeconomic Questions
Figure 1.4 shows the
distribution of income in
the United States.
The richest 20 percent
earn almost 50 percent of
total income while the
poorest 20 percent earn
only 4 percent of total
income.
Three Big Microeconomic Questions
The facts about for whom
raise the deeper question:
What determines earnings
and the distribution of
income that in turn
determine who gets the
goods and services
produced?
Microeconomics provides
some answers to this
question.
Three Big Macroeconomic Questions
Macroeconomics focuses on three big questions:
 What determines the standard of living?
 What determines the cost of living?
 Why does our economy fluctuate?
Three Big Macroeconomic Questions
What Determines the Standard of Living?
The standard of living is the level of consumption that
people enjoy on the average and is measured by average
income per person.
Three Big Macroeconomic Questions
Figure 1.5 shows income
per person per day in a
number of countries and
regions.
The United States has one
of the highest standards of
living, and the nations of
Africa have the lowest.
Three Big Macroeconomic Questions
Macroeconomics seeks to
explain differences in the
standard of living across
countries.
Macroeconomics also
seeks to explain the rate at
which the standard of
living changes.
Three Big Macroeconomic Questions
What Determines the Cost of Living?
The cost of living is the amount of money it takes to buy
the goods and services that a typical family consumes.
The cost of living in the United States is the number of
dollars it takes to buy the goods and services that a typical
family consumes.
Three Big Macroeconomic Questions
Table 1.1 shows the price
of a Big Mac in ten
countries.
Country
Currency
Price
U.K
Pound
1.90
U.S.
Dollar
2.50
Brazil
Real
2.95
The number of money units
varies a lot, but the cost is
similar in each country.
S. Africa
Rand
9.00
China
Yuan
9.90
France
Franc
18.50
What matters is the rate at
which prices change.
Russia
Ruble
39.50
Japan
Yen
294
Chile
Peso
1,260
Italy
Lira
4,500
Three Big Macroeconomic Questions
A rising cost of living is called inflation.
A falling cost of living is called deflation.
Inflation brings a shrinking value of the dollar and deflation
brings a rising value of the dollar.
Macroeconomics seeks to explain the forces that
determine the cost of living and the inflation (or deflation)
rate.
Three Big Macroeconomic Questions
Why Does Our Economy Fluctuate?
The business cycle is the periodic but irregular up-anddown movement in production and jobs in an economy.
During 2001, the U.S. economy entered a mild
recession—production and jobs shrank.
During the 1990s, the U.S. economy enjoyed a prolonged
expansion—production and jobs increased.
Figure 1.6 on the next slide illustrates the phases and
turning points of a business cycle.
Three Big Macroeconomic Questions
Three Big Macroeconomic Questions
Why Does Our Economy Fluctuate?
Economists remain unsure about the sources of economic
fluctuations and about the actions that might be taken to
smooth the economy.
But in your study of macroeconomics, you will learn what
economists have discovered about economic fluctuations.
The Economic Way of Thinking
Choices and Tradeoffs
The economic way of thinking places scarcity and its
implication, choice, at center stage.
You can think about every choice as a tradeoff—an
exchange—giving up one thing to get something else.
The classic tradeoff is “guns versus butter.”
“Guns” and “butter” stand for any two objects of value.
The Economic Way of Thinking
Microeconomic Tradeoffs
The three microeconomic questions become sharper
when we think in terms of tradeoffs.
“What?” Tradeoffs arise when people choose how to
spend their incomes, when governments choose how to
spend their tax revenues, and when businesses choose
what to produce.
The Economic Way of Thinking
Microeconomic Tradeoffs
“How?” Tradeoffs arise when businesses choose among
alternative production technologies.
“For Whom?” Tradeoffs arise when choices change the
distribution of buying power across individuals.
Government redistribution of income from the rich to the
poor creates the big tradeoff—the tradeoff between
equality and efficiency.
The Economic Way of Thinking
Macroeconomic Tradeoffs
Standard of Living Tradeoffs arise when we choose
between current consumption and activities that increase
our standard of living.
Activities such as saving and investing, education, and
research increase future production and consumption
possibilities, which increases the standard of living.
The Economic Way of Thinking
Macroeconomic Tradeoffs
An Output-Inflation Tradeoff arises when policymakers
choose how much inflation to endure in order to maintain a
high level of production.
An output-inflation tradeoff arises because a policy
action that lowers inflation also lowers output and a policy
action that boosts output increases inflation.
The Economic Way of Thinking
Opportunity Cost
Thinking about a choice as a tradeoff emphasizes cost as
an opportunity forgone.
The highest-valued alternative that we give up to get
something is the opportunity cost of the activity chosen.
The Economic Way of Thinking
Margins and Incentives
People make choices at the margin, which means that
they evaluate the consequences of making incremental
changes in the use of their resources.
The benefit from pursuing an incremental increase in an
activity is its marginal benefit.
The opportunity cost of pursuing an incremental increase
in an activity is its marginal cost.
The Economic Way of Thinking
Margins and Incentives
Marginal benefit and marginal cost act as an incentive—an
inducement to take a particular action.
For any activity, if marginal benefit exceeds marginal cost,
people have an incentive to do more of that activity
If marginal cost exceeds marginal benefit, people have an
incentive to do less of that activity.
Economists seek to predict choices by looking at changes
in incentives.
Economics: A Social Science
Social Science
Economics is a social science.
Economists distinguish between two types of statements:
What is—positive statements
What ought to be—normative statements
A positive statement can be tested by checking it against
facts
A normative statement cannot be tested.
Economics: A Social Science
Social science
The task of economic science is to discover positive
statements that are consistent with what we observe in the
world and that enable us to understand how the economic
world works.
This task is large and breaks into three steps:
 Observation and measurement
Model building
Testing models
Economics: A Social Science
Observation and Measurement
Economists observe and measure economic activity,
keeping track of such things as:
Quantities of resources
Wages and work hours
Prices and quantities of goods and services produced
Taxes and government spending
Quantities of goods and services bought from and sold
to other countries
Economics: A Social Science
Model Building
An economic model is a description of some aspect of
the economic world that includes only those features of
the world that are needed for the purpose at hand.
Economics: A Social Science
Testing Models
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.
A theory is a bridge between a model and reality. It is a
proposition about which model works.
Economics: A Social Science
Obstacles and Pitfalls in Economics
Economists cannot easily do experiments and most
economic behavior has many simultaneous causes.
To isolate the effect of interest, economists use the logical
device called ceteris paribus or “other things being equal.
Economists try to isolate cause-and-effect relationships by
changing only one variable at a time, holding all other
relevant factors unchanged.
Economics: A Social Science
Obstacles and Pitfalls in Economics
Two common fallacies that economists try to avoid are:
The fallacy of composition, which is the false statement
that what is true for the parts is true for the whole or what
is true for the whole is true for the parts.
The post hoc fallacy from the Latin term “post hoc, ergo
propter hoc”—means “after this, therefore because of this,”
which is the error of reasoning that a first event causes a
second event because the first occurs before the second.
Economics: A Social Science
Agreement and Disagreement
Economists are often accused of contradicting each other.
In contrast to the popular image, economists find much
common ground on a wide range of issues.
Page 14 of the textbook lists twelve economic propositions
that at least 70 percent of all economists polled agreed on.
WHAT IS
ECONOMICS?
THE END
1
CHAPTER