Econ 201
Lecture 1.3
Economic Way of Thinking
1-7-2009
Overview
• What is Economics
– Trying to define it
• The scientific method
• The economic way of thinking
– “organizing your facts”
– Applying the scientific method to a problem
– Narrow versus broad economics
– Fundamental basis for economic theory
What is Economics?
• “Theory of Economics does not furnish a
body of settled conclusions inevitably
applicable to policy. It is a method … a
way of thinking ..to draw correct
conclusions.”
– John Maynard Keynes
• It is both descriptive of what has happened
as well as predictive
What is Economics?
• A Science?
– Consists of theories that help us understand
and make valid predictions about the real
world (J. Hirschliefer, UCLA)
• Test, validate and accept/reject theories
– subjecting theories to empirical analysis
• What does it seek to explain?
– How a market societies organizes and
coordinates itself to:
• Produce and allocate goods and services
What is Economics?
• Social/Market Coordination
– For individuals:
• How individuals make choices among various goods, how to
allocate time, with a scarcity constraint (e.g., income, time)
– For firms:
• How firms decide to enter which markets
• How firms decide how much and what to produce in
response to the market’s price signal
– For the market
• How does the market’s price get determined?
Who are the Principal Actors?
• Consumers
– Supply labor to the market to earn income
– Purchase goods from firms
• Firms
– Which goods are produced in response to consumer
demand
– What technology and which inputs are used
• Government
– Establishes the “rules” of the game, e.g. property
rights and illegal behavior
– Provide incentives (taxes, subsidies), guarantees
property and legal rights
Scientific Method
What is the Study of Economics?
• The study of economics involves learning
how to organize facts the way economists
do.
– Or what Paul calls – learning the economic way of
thinking
• An alternative way of thinking
– good-versus-bad" model (conspiracy theories)
• two conflicting groups: good people and bad people.
• zero-sum game: one person's gain is another's loss.
• evil motives, possessed by the bad people, lead to bad
results unless these people are in some way controlled.
Good motives lead to good results.
An Example
• Looking at the recent history of gas/oil
prices
Testing Economic Hypotheses
• Explaining the past increase to $4/gal (~50%)
– A demand-side hypothesis
• Increase in consumption from newly industrialized nations increased
(shifted) the demand for gasoline
– A supply-side hypothesis
• Reduced refinery capacity reduced the supply of gas (refined oil)
– Good/Bad Guy Model (Mike Mays, 5/08 before Congress)
• Increase in demand from speculators who buy and sell promises to
deliver oil at a later date is almost equal to the increase in demand
from China
• Empirical evidence
– World-wide consumption increased by only 3-4%
• Insufficient to account for most of the increase in price
– Increase in demand by speculators even less
• Refinery capacity did diminish by ~30-40%
Broad versus Narrow Economics
• Narrow economics
– Theory of behavior based on “incentives” is restricted
to analysis of human behavior in the marketplace
• E.g., impact of the “cow gas” tax
• Broad economics
– Incentives are not limited to economic incentives,
such as prices, taxes or income
– Behavior based on incentives is not restricted to only
markets
• E.g., CIA and Afghan warlords
Narrow Economics
• ANPR (Notification of Proposed Rule Making),
– Give EPA authority to regulate greenhouse gas
• not only greenhouse gas from manmade sources like
transportation and industry,
• also “stationary” sources which would include livestock.
• New York Farm Bureau estimates:
– Basic facts:
• $175 per cow, and $87.50 per head of beef cattle
• $20 per hog,”
• Apply to >= 25 dairy cows, 50 beef cattle or 200 hogs
– Impact: add between 7 and 8 cents per gallon of milk
costs to farmers
Broad Economics
• Afghan warlords and Viagra
(http://www.telegraph.co.uk/)
– Whatever it takes to make friends and influence
people – whether it's building a school or handing out
Viagra," one veteran CIA officer told The Washington
Post.
– According to the newspaper, pills to boost the libidos
of Afghan tribal patriarchs are the latest in a long line
of inducements including medicine or operations for
family, toys and school equipment, tooth extractions
and visas
– The trick was to identify a means of pleasing the CIA
source enough to guarantee his loyalty without
making it obvious to others that he's being rewarded.
What is Economic
Theory Based On?
• “all social phenomena emerge from the actions and
interactions of individuals who are choosing in response
to expected benefits and costs” (Heyne)
– Focus on choice under constraint
• Constraint  scarcity
– Scarcity: can’t have all of the things you want
» Even if unlimited income and no natural resource
constraints => time
• In reality – all are limited and choices must be
made about how to use them – or there would be
no economic problem
So What is Economics?
• Economics is the study of the:
– Choices we make
– Constraints that we face
– Tradeoffs that are made because of scarcity
Basic Behavioral Postulates
1.
For each person some goods are scarce
- have to make choices (core of the economic problem)
2.
Each person desires many goods and services
- tradeoffs
3.
Each person is willing to forsake some of an economic good to
get more of other economic goods
- Opportunity costs
4.
More one has of any good, the lower it personal marginal value
- Diminishing marginal value
5.
6.
Not all people have the same tastes and preferences
People are innovative and rational
- Does not mean we know everything and don’t make mistakes, but we do
learn from them and don’t repeat them
Scarcity
• Past Examples
– Malthus
• Hypothesized that continued high rate of population growth would
outstrip world’s ability to produce food
– Mayan and Eastern Island examples
• Current issues
– Climate Change
• Affecting human health, ecosystem, moral dimension and requiring
international coordination
– Water Accessibility
• Increasing water stress from both supply and sanitation
– Meeting the Challenges
• Economic activities and environmental problems
• International cooperation
Overview: Welcome to Economics!
• http://ingrimayne.com/econ/Introduction/Overvie
w1.html
• After you finish this unit, you should be able to:
– Explain what the term "invisible hand" means and
who first used it.
– Give at least one common definition of economics.
– State what Malthus thought about population growth.
– Explain how Popper defines scientific statements.
– Distinguish between positive and normative
statements.
– Explain what scarcity, choice, and self-interest have
to do with economics.