Econ 100 Lecture 1.3 Ch. 1 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 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.