Topic 1 Introduction: Principles Of Economics Chapter 1 Topic Outline 1. What is Economics 2. Three Key reasons to Study Economics 3. Microeconomics, Macroeconomics and the Diverse fields of Economics 4. The Method of Economics - Positive and Normative Economics - Descriptive Economics and Economic Theory - Theories and Models 5. Economic Policy and Criteria for evaluating Economic Policy 6. How to read and understand Graphs Learning Objectives • Identify three key reasons to study economics • Describe microeconomics, macroeconomics and the diverse fields of economics • Discuss the fundamentals of economic methods, theories and models • Identify four main goals for evaluating economic policies and outcomes • Understand how data can be graphically represented Points To Wonder • • • • • • • • • • The Study of economics should begin with a sense of wonder. Pause for a moment and consider a typical day in your life. It might start with a Bagel made in a local bakery with flour produced and wheat grown indifferent places in Israel. You spill coffee from Columbia on your shirt probably made in India. Later you will drive a car made in Japan. The car is probably made out of Japan. The engine would probably be manufactured in Korea, use spark plugs made somewhere else and have tires made in the USA. Later still, you log onto the Web with a laptop assembled in Indonesia and parts made in China and skype with a relative in England and you call a buddy on your iPhone with a friend in Australia or in a half a dozen other countries. You use or consume thousands of things. Somebody organized men and women and materials to produce and distribute them. Thousands of decisions went into their completion. Somehow, they got to you. In Israel, about 4 million people work at thousands of different jobs producing billions of shekels of goods and services. Some cannot find work, some choose not to work. Some are rich and other are poor. Some countries are wealthy. Others are impoverished. Some are growing. Some are not. Some businesses are doing well. Others are going bankrupt Ponder? Why is this so? What is economics? Economics is a behavioral or social science. Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. The key word in this definition is choose. In large measure it is the study of how people make choices. The choices that people make, when added up, translate into societal choices. Because of Scarcity ➾ need to make choices This implies tradeoffs: Scarcity is a necessary condition for tradeoffs to occur What is economics? Shattering misconceptions: • Economics is NOT the same as business. • Economics is NOT about making money in stocks, bonds and estate. • Economics is NOT (only) about money. Scarcity People’s wants are greater than the economy’s ability to produce desirable goods & services Poverty is about hunger or of not having enough money to meet basic needs including food, clothing and shelter. Scarcity ≠ Poverty: • A homeless man who wants to eat but can only find food that will give him a fatal allergic reaction faces scarcity • A university student who wants to own a Mustang convertible but cannot faces scarcity Non-Satiation Assumption More goods are always preferable to fewer goods; people are never satiated People will always pick a job with the highest wage People will always eat 10 pieces of pizza instead of 1 Economics The study of satisfying unlimited wants and needs with limited resources. Why study economics? Several reasons to study economics: • to learn economic terminology, • to learn a way of thinking, • to understand society, to understand global affairs and to be an informed citizen and understand policy issues Why study economics? • To learn economic terminology “The language of Economics”. - You need to learn French to participate in a French literature class. - You need to learn chemical notation to succeed in Chemistry. - You need economic language to understand Economics. - “demand” and “demanded quantity”. Why Study economics? The Study Of Economics teaches us a way of thinking that helps us make decisions T1 Principle 1 : People face trade offs Principle 2 : The Cost of Something Is What You Give Up to Get It Principle 3: Rational People think at the Margin Principle 4: People Respond to Incentives T2 Principle 5: Trade can make Everyone Better Off Principle 6: An Economy’s standards Depends on its Ability to Produce Goods and Services T4 Principle 7: Markets are usually a Good way to Organise Economic Activity T11Principle 8: Governments can Sometimes Improve Market Outcomes M Principle 9: Prices Rise When Governments Print Too Much Money A Principle 10: Society Faces a Short-Run Trade Off Between Inflation C and Unemployment Why study economics? • TO LEARN A WAY OF THINKING Economics has Four fundamental concepts: – Opportunity cost – Marginalism – Efficiency of markets – The rationality Assumption Why study economics? • A key concept that that occurs in analysing decisions is opportunity cost/Alternative cost • In Economics, Costs do not necessarily involve money. They include What we have to give to get what we have. • Opportunity cost The best alternative that we forgo, or give up, when we make a choice or a decision. • Opportunity Costs arise because resources are scarce or limited • Nearly all decisions involve trade-offs Microeconomics is about the study of tradeoffs • The “Full Cost” of making a specific choice includes (Opportunity Cost); what we give up by not making the best alternative choice. • Only the highest valued tradeoff(s) counts • • Why study economics? Opportunity costs are central to cost-benefit analysis – e.g., the cost of your decision to attend school (ML/MT) • Explicit cost is tuition • Opportunity cost includes explicit cost and foregone earnings • Don’t count things like the cost of food, which are incurred anyway (in all alternatives when making a decision). Opportunity costs can change. E.g. If there are ample rains in India, the opportunity cost of sending children to school is high. In a drought it is low. • The notion of opportunity cost is also helpful when weighting Present and Expected Future Costs and Benefits What is the cost, born by the Israeli economy, of the security provided by an IDF soldier? Why study economics? • Cost Benefit Analysis Cost-Benefit Analysis Economic reasoning in making decisions by comparing only the relevant costs and benefits that arise from the decision ECONOMIC DECISION MAKING RULE: • If the benefits of an action exceeds its costs: DO IT. • If the costs of an action exceeds its benefits: DO NOT DO IT. • In case of more than one alternative: CHOOSE THE ACTION WITH THE GREATEST NET BENEFITS. Why study economics? • Marginalism • Usually decisions are not “all-or-nothing” • Decisions can also be about “more” or “less” Thinking at the margin • Involves consideration of the benefits/costs of doing marginally more or marginally less of an activity It involves “Successive”/”step by step” analysis”: ADDITIONAL costs are compared with ADDITIONAL benefits. • e.g., adding a side trip to Boston whilst on a trip to New York • e.g., studying more or less • e.g., increasing/decreasing air quality standards Why study economics? • Marginal and Sunk Costs • Marginal cost - The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. • Sunk costs - Costs that cannot be avoided, regardless of what is done in the future, because they have already been incurred. They are past costs – therefore are not counted in a cost benefit decision – e.g.: Cost of factory, rental costs, training costs, membership costs. Wy study economics? Marginal Cost, Marginal Benefit • M.C.(marginal cost) is the extra cost associated with the additional activity…. • M.B.(marginal benefit) is the extra benefit associated with the additional activity…. • $’s are used to measure these in order to facilitate comparisons Why study economics? • Efficiency of the Markets – “No free lunch” Economists often loosely refer to “good deals” or risk-free ventures as profit opportunities Using the term loosely , a profit opportunity exists at the checkout lines when one line is shorter than others. There are clearly times when profit opportunities exist. The General view is that large profit opportunities are rare • Efficiency of the market A market in which profit opportunities are eliminated almost instantaneously, are said to be efficient markets. The Rationality Assumption - a key concept in economics • Rational decision making – is also a key concept in economics. • People have purposes and limited means possibilities, budget constraints. • People are smart, calculate, predict, anticipate, etc. Selfish • People would rather take actions that benefit them versus actions that are neutral or harm them. An individual makes decisions based on maximizing his or her own self-interest. Individuals select among the different means the best way of achieving their goals. Therefore, people do not intentionally make decisions that would leave them worse off. Behavioral Economics is an integration of psychology into The Rationality Assumption Rationality: Behavioral: People are: 1. smart (calculate, predict, anticipate, etc.) People are: 1. Bounded by rationality (prices ending in 0.99). 2. Selfish 2. Fairness, inequality aversion. The economic rationality principle is based on the postulate that people behave in rational ways and consider options and decisions within logical structures of thought, as opposed to involving emotional, moral, or psychological elements. Why study economics? TO UNDERSTAND SOCIETY BETTER At no time has the impact of economic change on a society been more evident than the Industrial Revolution Industrial Revolution The period in England during the late eighteenth and early nineteenth centuries in which new manufacturing technologies and improved transportation gave rise to the modern factory system and a massive movement of the population from the countryside to the cities. Similar changes continue to affect the character of life in more recent times. Since the last 50 years the rate of change is phenomenal. The Study of Economics is an essential part of the study of Society You cannot begin to understand how a society functions without knowing something about its economic history and its economic system. Learning to think in this very powerful way will help you better understand the world. How has Covid effected where we live and is that related to economics? Why study economics? iPod and the World With the advent of globilisation the world has become a smaller place. Before your customers were near you or perhaps from the next town or somewhere in your country. You Suppliers were also around the corner or from near by. With Globilisation both our Customers and Suppliers can be from anywhere in the world The line between “made” and “assembled” has become blurred. A sticker that says “Made in China” can often be misleading. The iPod is composed of many small parts, and it is almost impossible to accurately tell exactly where each piece was produced without pulling it apart. From an economics point of view, one often has to dig deep to see what is really going on. Why study economics? TO UNDERSTAND GLOBAL AFFAIRS The events of September 11, 2001, dealt a blow to the tourism industry and left airlines in deep financial trouble. How does terrorism effect tourism in Israel An understanding of economics is essential to an understanding of global affairs. Why study economics? To be an informed citizen requires a basic understanding of economics. A knowledge of economics is essential to be an informed voter. Which issues/policies do you vote for? When we participate in the political process, we are voting on issues that require a basic understanding of economics. Learning to think like an economist not only generates a higher wage but provides insurance against volatility in the economy. Students of economics are less hurt when graduating in a recession than students of sociology or law The Scope of Economics DIVERSE FIELDS OF ECONOMICS Economics encompasses a broad range of inquiry and is linked to many other disciplines • Individual economists focus their research and study in many different areas. • Some are concerned with economic history or the history of economic thought. • Others focus on international economics or growth in less developed countries • Economics also differ in the emphasis they place on theory. • Some economists specialize in developing new theories, • Whereas other economists spend their time testing the theories of others. • Some economists hope to expand the frontiers of knowledge • Whereas other economists are more interested in applying what is already known to the formulation of public policies The Scope of Economics There are two major divisions of economics – Microeconomics and Macroeconomics MICROECONOMICS AND MACROECONOMICS • Microeconomics The branch of economics that examines the functioning of individual industries and the behavior of individual decision-making units—that is, business firms and households. • Macroeconomics The branch of economics that examines the economic behavior of aggregates— income, employment, output, and so on—on a national scale. Microeconomics looks at the individual unit—the household, the firm, the industry. It sees and examines the “trees.” Macroeconomics looks at the whole, the aggregate. It sees and analyzes the “forest.” The Scope of Economics TABLE 1-1 - Examples of Microeconomic and Macroeconomic Concerns DIVISION OF ECONOMICS Microeconomics Macroeconomics PRODUCTION PRICES INCOME EMPLOYMENT Production/output in individual industries and businesses Price of individual goods and services Distribution of income and wealth Employment by individual businesses and industries How much steel How much office space How many cars Price of medical care Price of gasoline Food prices Apartment rents Wages in the auto industry Minimum wage Executive salaries Poverty Jobs in the steel industry Number of employees in a firm Number of accountants National production/output Aggregate price level National income Employment and unemployment in the economy Total industrial output Gross domestic product Growth of output Consumer prices Producer prices Rate of inflation Total wages and salaries Total corporate profits Total number of jobs Unemployment rate The Scope of Economics The Diverse Fields Of Economics • • • • • • • • • • • • • • • Behavioural Economics Comparative Economic Systems Econometrics Economic Development Economic History Environmental Economics Finance Health Economics The History of Economic Thought Industrial organization International economics Labour Economics Law and Economics Public Economics Urban and Regional economics The Diverse Fields of Economics Behavioral economics Do aggregate household savings increase when we automatically enroll people in savings programs and let them opt out as opposed to requiring them to sign up? Comparative economic systems How does the resource allocation process differ in market versus command-and-control systems? Econometrics What inferences can we make based on conditional moment inequalities? Economic development Does increasing employment opportunities for girls in developing nations increase their educational achievements? Economic history How did the growth of railroads and improvement in transportation more generally change the U.S. banking systems in the nineteenth century? The Diverse Fields of Economics Environmental economics What effect would a tax on carbon have on emissions? Is a tax better or worse than rules? Finance Is high frequency trading socially beneficial? Health economics Do co-pays by patients change the choice and use of medicines by insured patients? The history of economic thought How did Aristotle think about just prices? Industrial organization How do we explain price wars in the airline industry The Diverse Fields of Economics International economics What are the benefits and costs of free trade? Does concern about the environment change our views of free trade? Labor economics Will increasing the minimum wage decrease employment opportunities? Law and economics Does the current U.S. patent law increase or decrease the rate of innovation? Public economics Why is corruption more widespread in some countries than in others? Urban and regional economics Do enterprise zones improve employment opportunities in central cities? The Method of Economics Economics asks and attempts to answer two kinds of questions: Positive and Normative Positive Economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It describes what exists and how it works, without making any statements about how they ought-to be. e.g., “The increased concentration of CO2 in the atmosphere is causing the climate to change.” Normative Economics An approach to economics that analyzes outcomes of behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics. e.g., “Should we reduce or eliminate inheritance taxes? Most normative questions involve positive questions. To know whether the Government should take a particular action, we must know first if we can and second what the consequences are likely to be. The Method of Economics THEORIES AND MODELS As in Physics, Chemistry or Political Science theorists build formal models of behaviour Model - A formal statement of a theory, usually a mathematical statement of a presumed relationship between two or more variables. Variable A measure that can change from time to time or from observation to observation. Ockham’s razor The principle that irrelevant details should be cut away Because all models simplify reality by stripping part of it away, they are abstractions. Although abstraction is a powerful tool for exposing and analysing specific aspects of behaviour , it is possible to over simplify the phenomenon. The Method of Economics Models can be expressed in Words, Graphs, and Equations The most common method of expressing the quantitative relationship between two variables is graphing that relationship on a two-dimensional plane. The Method of Economics Economic Theory and Descriptive Economics Economic theory postulates a statement or set of related statements about cause and effect, action and reaction. It is a set of ideas and principles that outline how different economies function. Depending on their particular role, an economist may employ theories for different purposes. Descriptive (empirical) economics consists of a compilation of data that describe phenomena and facts. It is often used to test theories. The Method of Economics In a Model there are two types of Variables Exogenous variables An exogenous variable is one that comes from outside the model, is unexplained by the model, and its value is predetermined. This variable is independent, autonomous, i.e., unaffected by the workings of the model. Endogenous variables - Dependent Variables whose values are determined within the model and are explained by the model. For example, in a supply and demand model of an agricultural market, changes in the weather or in consumer income would be exogenous variables that might shift the supply and demand curves; the price and quantity of trade would be the endogenous variables explained by the model. The Method of Economics It is usually true that whatever you want to explain with a model depends on more than one factor To isolate the impact of a single factor, we use in Economics, the device of ceteris paribus, or all else equal The ceteris paribus assumption provides a useful way to analyse the relationship between two variables while the values of other variables are held unchanged. Using the device of ceteris paribus is one part of the process of abstraction. In formulating economic theory, the concept helps us simplify reality to focus on the relationships that interest us. The Method of Economics In much of Economics, we are interested in cause and effect In formulating theories and models, it is especially important to separate causation from correlation. Causation means one thing causes another. Action A causes outcome B Correlation or dependence is any statistical relationship, whether causal or not between two random variables Sorting out causality from correlation is not always easy, particularly when one wants a quantitative answer to a question A common error is made when thinking about causation : If Event A happens before B, it is not necessarily true that A caused B. Because one event happens before another, the second event does not necessarily happen as a result of the first. To assume that “after” implies “because” is to commit the fallacy of post hoc, ergo proper hoc Literally “after this in time, therefore because of this.” The Method of Economics Testing Theories and Models: Empirical Economics In science, a theory is rejected when it fails to explain what is observed or when another theory better explains what is observed The collection and use of data to test economic theories is called empirical economics Economics in Practice Would you expect senior students who choose their own roommates to have more or less similar grades than college freshmen who are assigned as roommates? Why or why not? • Several studies of the effect of roommates on college grades have been conducted to help to sort out causality in peer effects. • One study looked at randomly assigned freshman roommates in one college to test the peer effects from different types of roommates. • The author found strong roommate effects on grade point average, effort in school, and fraternity membership. Economic Policy Economic theory helps understand how the world works The formulation of Economic Policy requires a second step What do we want to change? Why? What is good and what is bad about the way the system is operating? Can we make it better? Economic Policy CRITERIA FOR EVALUATING ECONOMIC PLOLICY The formulation of ECONOMIC POLICY requires us have objectives about what we want to change and Why. We need to be specific about the grounds for judging one outcome as being superior to another. What does it mean to be better? Criteria for judging economic outcomes: 1. Efficiency 2. Equity 3. Growth 4. Stability Economic Policy CRITERIA FOR EVALUATING ECONOMIC POLICY Efficiency In economics, efficiency means allocative efficiency. An efficient economy is one that produces what people want at the least possible cost. If the system allocates resources to the production of goods and services that nobody wants, it is inefficient Equity Fairness. Economic Policy CRITERIA FOR EVALUATING ECONOMIC PLOCY Growth Economic growth - An increase in the total output of an economy. Some policies discourage economic growth and others encourage it. Policies can be designed to encourage the development of new production techniques If businesses and the wealthy people invest their wealth outside the country, growth in their home country may be slowed Stability Economic Stability - A condition in which national output is growing steadily, with low inflation and full employment of resources. How To Read And Understand Graphs HOW TO READ AND UNDERSTAND GRAPHS A graph is a two dimensional representation of a set of numbers, or data. FIGURE 1-1 A Cartesian Coordinate System How To Read And Understand Graphs GRAPHING TWO VARIABLES ON A CARTESIAN COORDINATE SYSTEM The Cartesian coordinate system is the most common method of graphing two variables. This system is constructed by simply drawing two perpendicular lines: a horizontal line, or X-axis, and a vertical line, or Y-axis. The axes contain measurement scales that intersect at 0 (zero). This point is called the origin. The point at which the graph intersects the Y-axis is called the Y-intercept. The point at which the graph intersects the X-axis is called the X-intercept X– Y+ X+ Y+ On the vertical scale , positive numbers lie above the horizontal axis(i.e. above the origin) and negative numbers below it. On the horizontal scale , positive numbers lie to the right of the vertical axis (to the right of the origin) and negative numbers lie to the left of it. X– Y- X+ Y- The first number is measured on the X-axis and the second on the Y-axis FIGURE 1-2 A Cartesian Coordinate System How To Read And Understand Graphs PLOTTING INCOME AND CONSUMPTION DATA FOR HOUSEHOLDS TABLE 1-2 Total Disposable Personal Income in the United States, 1975–2005 (in billions of dollars) YEAR TOTAL DISPOSABLE PERSONAL INCOME YEAR TOTAL DISPOSABLE PERSONAL INCOME 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1,181.4 1,299.9 1,436.0 1,614.8 1,808.2 2,019.8 2,247.9 2,406.8 2,586.0 2,887.6 3,086.5 3,262.5 3,459.5 3,752.4 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 4,016.3 4,293.6 4,474.8 4,754.6 4,935.3 5,165.4 5,422.6 5,677.7 5,968.2 6,355.6 6,627.4 7,120.2 7,393.2 7,827.7 8,159.9 8,646.9 8,945.6 How To Read And Understand Graphs TIME SERIES GRAPH A time series graph shows how a single variable changes over time. FIGURE 1-3 Total Disposable Personal Income in the United States: 1975–2005 (in billions of dollars) Graphing Two Variables FIGURE 1-4 Average Household Consumption and Income TABLE 1-3 Consumption Expenditures and Income, 2012 Bottom fifth 2nd fifth 3rd fifth 4th fifth Top fifth Average Income Before Taxes Average Consumption Expenditures $ 9,988 27,585 47,265 75,952 167,010 $ 22,154 32,632 43,004 59,980 99,368 • The graph in Figure 1-4 displays the data from Table 1-3. • Along the horizontal scale (X-axis), we measure Average household income. Along the vertical scale (Y-axis), we measure Average household consumption. • Note: At point A, consumption equals $22,154 and income equals $9,988. At point B, consumption equals $32,632 and income equals $27,585. It is important to think carefully about what is represented by points in the space defined by the axes of a graph. Graphing Two Variables Plotting Income and Consumption Data For Households • positive relationship A relationship between two variables, X and Y, in which a decrease in X is associated with a decrease in Y and an increase in X is associated with an increase in Y. • negative relationship A relationship between two variables, X and Y, in which a decrease in X is associated with an increase in Y and an increase in X is associated with a decrease in Y. How To Read And Understand Graphs The slope of the line indicates whether the relationship between the variables is positive or negative. How much of a response there is in Y (the variable on the vertical axis) when X (the variable on the horizontal axis) changes. The slope of the line is computed as follows: Y2 Y1 Y X X 2 X1 How To Read And Understand Graphs FIGURE 1-5 A Curve with (a) Positive Slope and (b) Negative Slope An upward-sloping line describes a positive relationship between X and Y. A downward-sloping line describes a negative relationship between X and Y. A positive slope indicates that increases in X are associated with increases in Y and that decreases in X are associated with decreases in Y. A negative slope indicates the opposite—when X increases, Y decreases; and when X decreases, Y increases. How To Read And Understand Graphs Slope: Positive and Increasing Slope: Negative and Increasing Slope: Positive and Decreasing Slope: Negative, then Positive Slope: Negative and Decreasing Slope: Positive, then Negative FIGURE 1-6 Changing Slopes Along Curves ADAM SMITH: THE FATHER OF ECONOMICS IDEAS CHANGE THE WORLD Adam Smith ( 6 September 1723 – 17 July 1790) was a Scottish economist and philosopher who was a pioneer in the thinking of political economy and key figure during the Scottish Enlightenment.
