Chapter 1:
Economics and
Economic
Reasoning
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
What Economics Is

Economics is the study of how individuals,
firms, and governments make optimal
choices from among a set of alternatives
when facing scarce resources.
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2
What Economics Is

Key words:

choice
alternative
scarcity


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3
What Economics Is

Scarcity exists because individuals want
more than available resources can produce.

Wants are unlimited, but resources are
limited.
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4
What Economics Is

The degree of scarcity is constantly changing.

The quantity of goods, services, and usable
resources depends on technology and human
action.
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5
What Economics Is

Any economic system must solve three
central coordination problems:



What, and how much, to produce.
How to produce it.
For whom to produce it.
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6
What Economics Is

In this course you will learn:



Economic reasoning.
Economic terminology.
Economic insights economists have about issues,
and theories that lead to those insights.
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7
What Economics Is

To understand the economy, you need to
learn:

Information about economic institutions.

Information about the economic policy options
facing society today.
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8
A Guide to Economic Reasoning

Economic reasoning is making decisions by
comparing costs and benefits.
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9
Marginal Costs and Marginal Benefits

The relevant costs and benefits are the
expected incremental, or additional, costs
incurred and the expected incremental
benefits of a decision.
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10
Marginal Costs and Marginal Benefits

Economist use the term marginal when
referring to additional or incremental.
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Marginal Costs and Marginal Benefits

Marginal cost – the additional cost to you
over and above the costs you have already
incurred.

This means not counting sunk costs – costs
that have already been incurred and cannot
be recovered.
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12
Marginal Costs and Marginal Benefits

Marginal benefit – the additional benefit
above and beyond what you’ve already
accrued.
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13
Marginal Costs and Marginal Benefits

According to the economics decision rule:

If the relevant benefits of doing something exceed
the relevant costs, do it.

If the relevant costs of doing something exceed
the relevant benefits, don’t do it.
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14
Economics and Passion

Economic reasoning is based on the premise
that everything has a cost.

It leads to a better society for the majority of
people.
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15
Opportunity Cost

The Opportunity cost of the chosen activity
is the value of the next-best alternative to the
activity you have chosen.

Opportunity cost is the basis of cost/benefit
economic reasoning.
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16
Opportunity Cost

In economic reasoning, opportunity cost must
be less than the benefit of what you have
chosen.
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17
Economic and Market Forces

The opportunity cost concept applies to all
aspects of life.

It is fundamental to understanding how
society reacts to scarcity.
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18
Economic and Market Forces

When goods are scarce, they must be
rationed.

Rationing is the mechanism for determining
who gets what.
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19
Economic and Market Forces

Economic reality is controlled by three forces:

Economic forces (the invisible hand).

Social and cultural forces.

Political and legal forces.
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20
Economic and Market Forces

Economic forces are the necessary
reactions to scarcity.

A market force is an economic force that is
given relatively free rein by society to work
through the market.
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21
Economic and Market Forces

Market forces ration quantity by changing
prices.

When there is a shortage, the price goes up.

When there is a surplus, the price goes
down.
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22
Economic and Market Forces

The invisible hand is the price mechanism -the rise and fall of prices -- that guides our
actions in a market.
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23
Economic and Market Forces

Political and social forces often work together
against the invisible hand.

What happens in society can be seen as a
reaction to, and interaction of, the invisible
hand, political and legal forces, and social
and cultural forces.
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24
Theories, Models and Assumptions

General insights into how economies work
are often based on generalizations called
economic theories.
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25
Theories, Models and Assumptions

Economic theories are abstract.

A theory is often embodied in an economic
model or an economic principle.
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26
Theories, Models and Assumptions

Economic model – a set of simple
behavioural assumptions to explain decision
making.
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27
Theories, Models and Assumptions

Economic principle – a commonly held
insight stated as a law or general
assumption.
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28
Theories, Models and Assumptions

Economists cannot test their models with
controlled experiments.

It is impossible to hold “other things
constant,” as is done in laboratory
experiments.
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29
Theories, Models and Assumptions

Theories, models, and principles must be
combined with a knowledge of real-world
economic institutions to arrive at a specific
policy recommendation.

In order to understand the theory you must
understand the assumptions underlying the
theory.
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30
The Invisible Hand Theory

Economist have observed:

Price tends to fall when the quantity supplied is
greater than the quantity demanded.

Price tends rise when the quantity demanded is
greater than the quantity supplied.
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31
The Invisible Hand Theory

According to the invisible hand theory, a
market economy, through the price
mechanism, will allocate resources efficiently.

Efficiency means achieving a goal as
cheaply as possible.
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32
Economic Theory and Stories

Economic theory and its models are a
shorthand means of telling a story.

If you can’t translate a theory into a story, you
don’t understand the theory.
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33
Microeconomics and Macroeconomics

Economics is divided into two parts:
microeconomics and macroeconomics.
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34
Microeconomics

Microeconomics is the study of individual
decision making.

It considers household and business
decisions, market allocations and pricing
policies.
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35
Macroeconomics

Macroeconomics is the study of the
economy as a whole.

It considers the problems of inflation,
unemployment, business cycles, and
economic growth.
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36
Economic Institutions

In applying economic theory to reality, you
must know about economic institutions.

Economic institutions are the laws,
common practices, and social, political, and
religious organization, of a society.
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37
Economic Institutions

Economic institutions differ significantly
among nations.

They sometimes seem to operate in ways
quite different than economic theory predicts.
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38
Economic Policy Options

Economic policies are actions taken by
government to influence economic events.
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39
Economic Policy Options

To carry out economic policy effectively, one
must understand how the economic policy
might change institutions.
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40
Objective Policy Analysis

Objective policy analysis keeps the value
judgments separate from the analysis.

Subjective policy analysis is that which
reflects the analyst’s view of how things
should be.
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41
Objective Policy Analysis

To make clear the distinction between
objective and subjective analysis, economics
is divided into three categories:



Positive economics
Normative economics
Science of economics
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42
Objective Policy Analysis

Positive economics – the study of what is,
and how the economy works.

Normative economics – the study of what
the goals of the economy should be.
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43
Objective Policy Analysis

Science of economics – the application of
the knowledge learned in positive economics
to achieve the goals determined in normative
economics.
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44
Objective Policy Analysis

It is hard to maintain objectivity in the science
of economics.

It embodies the problems of both positive and
normative economics
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45
Policy and Social and Political Forces

The choice of policy options depends on
more than economic theory.

Political and social forces must be taken into
account when applying economic theory to
policy.
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46
Economics and Economic
Reasoning
End of Chapter 1
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47
The Language of Graphs
Chapter 1 Appendix
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48
Horizontal Number Line
A
-3
-2
-1
0
1
2
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3
4
5
49
Vertical Number Line
40
30
20
10
0
B
- 10
- 20
- 30
- 40
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50
Coordinate System
40
30
20
10
0
B
(1, 20)
A
1
2
3
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4
(4, 5)
5
51
From Table to Graph
A
B
C
D
E
Price of Qty of Pens
Pens
Bought per
(in dollars)
Day
$3.00
4
2.50
5
2.00
6
1.50
7
1.00
8
$3.00
Price of pens (in dollars)
Price Quantity Table
2.50
2.00
1.50
A
B
C
D
E
1.00
.50
0
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1 2 3 4 5 6 7 8
Quantity of pens bought
52
Price (in dollars)
Nonlinear Curve
$6
5
4
3
2
1
0
10
20
Quantity
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30
40
53
Slopes of Curves
c
10
9
8
7
Slope = 1
d
Rise = 1
Run = 1
A
Slope = 4
Slope = -4
6
Rise = 4
Rise = -4
5
B
4
2
Run = 1
Slope = -0.5
3
Run = 2
L
Slope = 1
b
e
0
1
2
e
a
Rise = -1
1
Run = 1
3
4
5
6
L
7
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8
9
E
Rise =1
Run = 1
10
11
54
Inverse and Direct Relationships
Inverse relationship:
When X goes up, Y goes down
When X goes down, Y goes up
Direct relationship:
When X goes up, Y goes up
When X goes down, Y goes down
X
X
Y
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Y
55
Maximum Point
Maximum
Slope = 0
A
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56
Maximum and Minimum Points
B
Slope = 0
Minimum
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57
Presenting Information Visually
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58
$14,000
Income (in dollars)
Income (in dollars)
The Importance of Scales
13,000
12,000
11,000
16,000
14,000
12,000
10,000
10,000
1992
$18,000
1994
1996
(a) Income over time (1)
1992
1994
1996
(b) Income over time (2)
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59
The Language of Graphs
End of Chapter 1 Appendix
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rights reserved.
60