Foundations of Economics:
(“Economics” – Chapter 1)
Three goals of the present discussion…
1. Define economics (along with the main branches of
microeconomics and macroeconomics)
2. Distinguish between fact-based and opinion-based
statements (positive/normative distinction)
3. Discuss how economists model human behavior (costbenefit analysis)
Economics is the social science that studies how people
make decisions in the face of scarcity and the resulting
impact of such decisions on both society as a whole and on
the individual members therein.
 Social Science => central focus of study is how people
behave and interact with each other
 Scarcity => resources (e.g., time, personal income,
amount of labor in economy) are available in finite,
limited amounts
 Since resources are scarce, decision makers face
tradeoffs: having more of one thing means getting
by with less of something else.
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Microeconomics versus Macroeconomics:
Microeconomics – the branch of economics which studies
how individual decision-makers behave and interact with
each other (often with a focus on how households and firms
behave and interact with each other in markets).
Macroeconomics – the branch of economics which studies
the functioning and performance of a society’s economy as
a whole (often with a focus on levels of and changes in
aggregate measures such as the unemployment rate,
inflation rate, and Gross Domestic Product growth rate).
Micro and Macro are closely related, since the performance
of the “economy as a whole” is a result of all of the
“individual decisions of every distinct household and firm.”
 e.g. – What is the effect of “more generous
unemployment benefits on labor market outcomes”?
 A Macroeconomist might attempt to determine the
impact of the policy change on the overall
unemployment rate for the economy
 But to do so properly, she would likely have to
address the “micro level issue” of how the change in
policy impacts the behavior of individual labor market
participants
 Microeconomics: focuses on the individual unit (i.e., it
examines the “trees”)
 Macroeconomics: focuses on the aggregate or whole
(i.e., it examines the “forest”)
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“Positive Statements” versus “Normative Statements”:
Positive Statement – a claim that attempts to describe how
the world actually is or how the world actually functions
 “fact based” statements
 simply provide observations or predictions, without
any judging of their desirability
Normative Statement – a claim that attempts to assess the
desirability of how the world is or functions, perhaps with
suggestions of things that could be done to improve matters
 involve “value judgments” and “priorities,” to make
comparisons on the relative desirability of different
options
Positive Statements can (in principle) be confirmed or
refuted by evidence/data. Normative Statements cannot be
so judged, since they involve values as well as facts.
Examples from Economics:
 Normative: the government should increase the
minimum wage to help poor people.
 Positive: a minimum wage increases unemployment
among young and unskilled workers.
Distinction between “Positive/Normative” is not unique to
economics => 8/2/1939 letter from Einstein to FDR:
 Positive: possible to make a uranium bomb.
 Normative: U.S. government should assist physicists
in the country working on related research.
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Albert Einstein
Old Grove Rd.
Nassau Point
Peconic, Long Island
August 2nd 1939
F.D. Roosevelt
President of the United States
White House
Washington, D.C.
Sir:
Some recent work by E.Fermi and L. Szilard, which has
been communicated to me in manuscript, leads me to expect
that the element uranium may be turned into a new and
important source of energy in the immediate future. Certain
aspects of the situation which has arisen seem to call for
watchfulness and, if necessary, quick action on the part of
the Administration. I believe therefore that it is my duty
to bring to your attention the following facts and
recommendations:
In the course of the last four months it has been
made probable - through the work of Joliot in France as
well as Fermi and Szilard in America - that it may become
possible to set up a nuclear chain reaction in a large mass
of uranium, by which vast amounts of power and large
quantities of new radium-like elements would be generated.
Now it appears almost certain that this could be achieved
in the immediate future.
This new phenomenon would also lead to the
construction of bombs, and it is conceivable - though much
less certain - that extremely powerful bombs of a new type
may thus be constructed. A single bomb of this type,
carried by boat and exploded in a port, might very well
destroy the whole port together with some of the
surrounding territory. However, such bombs might very well
prove to be too heavy for transportation by air.
The United States has only very poor ores of uranium
in moderate quantities. There is some good ore in Canada
and the former Czechoslovakia, while the most important
source of uranium is Belgian Congo.
In view of the situation you may think it desirable
to have more permanent contact maintained between the
Administration and the group of physicists working on chain
reactions in America. One possible way of achieving this
might be for you to entrust with this task a person who has
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your confidence and who could perhaps serve in an official
capacity. His task might comprise the following:
a) to approach Government Departments, keep them
informed of the further development, and put forward
recommendations for Government action, giving
particular attention to the problem of securing a
supply of uranium ore for the United States;
b) to speed up the experimental work, which is at
present being carried on within the limits of the
budgets of University laboratories, by providing
funds, if such funds be required, through his
contacts with private persons who are willing to make
contributions for this cause, and perhaps also by
obtaining the co-operation of industrial laboratories
which have the necessary equipment.
I understand that Germany has actually stopped the
sale of uranium from the Czechoslovakian mines which she
has taken over. That she should have taken such early
action might perhaps be understood on the ground that the
son of the German Under-Secretary of State, von Weizsäcker,
is attached to the Kaiser-Wilhelm-Institut in Berlin where
some of the American work on uranium is now being repeated.
Yours very truly,
(Albert Einstein)
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Disagreement Among Economists:
“Patient Protection and Affordable Care Act” => signed
into law by President Obama on 3/23/10
 3/11/10: 40+ economists (including Daniel Kahneman,
one of two co-recipients of the 2002 Nobel Prize in
economics) wrote a letter supporting the legislation
 the reforms “include serious measures that will slow
the growth of health care spending” and constitute a
“serious, multi-faceted initiative to improve the
quality and efficiency of American medical care”
 3/18/10: 130+ economists (including Vernon Smith, the
other co-recipient of the 2002 Nobel Prize in economics)
wrote a letter opposing the legislation
 the bill would “threaten jobs and decrease economic
growth” and “increase the cost of health coverage”
 Observation by Nobel Laureate Paul Samuelson in 1966:
“If Parliament were to ask six economists for an opinion,
seven answers would come back – two, no doubt, from the
volatile Mr. Keynes! If economists cannot agree among
themselves, how can the rest of the world be expected to
agree with them and to respect their recommendations?”
Why do economists so often appear to give conflicting
advice to policymakers? Two possible reasons:
i. they “disagree” about the validity of different positive
theories about how the world works.
ii. they have different “priorities” and “values” and
therefore differing normative views about what policy
should attempt to accomplish.
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 there is generally “more agreement” among economists
on Positive Statements than on Normative Statements.
 There is generally “more agreement” among economists
on statements about microeconomics than on statements
about macroeconomics.
All this being said, we do not want to overstate the degree
of disagreement => there is “general agreement” among
economists on the following:
1. A ceiling on rents reduces the quantity and quality of
available housing. [95.5%]
2. Tariffs and import quotas usually reduce the general welfare
of society. [94.1%]
3. The U.S. should NOT restrict employers from outsourcing
work to foreign countries. [90.1%]
4. Fiscal Policy has a significant stimulative impact on a less
than fully employed economy. [88.6%]
5. Cash payments increase the welfare of recipients to a greater
degree than do transfers-in-kind of equal cash value. [88.0%]
6. The government should restructure the welfare system along
the lines of a “negative income tax.” [85.3%]
7. The federal budget should be balance over the business cycle
rather than yearly. [85.2%]
8. The U.S. should eliminate agricultural subsidies. [85.2%]
9. A large federal budget deficit has an adverse effect on the
economy. [81.3%]
10. A minimum wage increases unemployment among young
and unskilled workers. [80.8%]
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How economists model human behavior…
Focus on choices made by rational decision makers. A
rational decision maker is someone with a well-defined
goal, who takes actions to achieve the goal as best as
possible.
There are typically both costs and benefits associated with
different actions.
 Total Benefits – the gains that a person realizes from
an action or outcome
 Total Costs – the burdens that a person incurs from an
action or outcome
Take deliberate care to think of and measure benefits and
costs as separate and distinct from each other. From here:
 Total Economic Surplus – the difference between
Total Benefits and Total Costs
Goal of a rational decision maker is to make Total
Economic Surplus as large as possible. This is typically
accomplished by applying the following principle:
“Cost-Benefit Principle” – a rational decision maker
should undertake an activity if and only if the Marginal (or
additional) Benefit of doing so is greater than the Marginal
(or additional) Cost of doing so.
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Example: Carl needs to decide how many days per week
he should spend growing carrots. His Total Benefits and
Total Costs (measured in dollar terms) are stated below:
Days worked
0
1
2
3
4
5
6
7
Total Benefits
0
60
105
140
165
180
190
195
Total Costs
0
20
40
60
80
100
120
140
Goal is to maximize Economic Surplus. Economic
Surplus refers to the difference between his Total
Benefits and Total Costs.
# Days
0
1
2
3
4
5
6
7
TB
0
60
105
140
165
180
190
195
Marg. Benefit
not defined
60-0 = 60
105-60 = 45
140-105 = 35
165-140 = 25
180-165 = 15
190-180 = 10
195-190 = 5
Marg. Cost
not defined
20 = 20-0
20 = 40-20
20 = 60-40
20 = 80-60
20 = 100-80
20 = 120-100
20 = 140-120
TC
0
20
40
60
80
100
120
140
 The best level is “4 days worked.”
 This gives an Economic Surplus of 165-80 = 85 (any
other level would result in a smaller Economic
Surplus).
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Insights on how rational people respond to incentives…
 Incentives Matter – The choices that people make are
highly dependent upon benefits and costs => as benefits
or costs change, people will often alter their behavior.
 “Incentive Principle” – (i) if the marginal benefit of an
activity increases, then a rational person will engage in
more of the activity, whereas (ii) if the marginal cost of
an activity increases, then a rational person will engage
in less of the activity.
Example: Decision to go to College.
 One Benefit: Higher Income. 2010: average income
of High School grad was $32,552; average income of
College grad was $53,976. Difference of $21,424.
 One Cost: Tuition and fees. $3,243 per semester over
8 semesters is a total of $25,944.
 Would it affect your decision to attend College if:
- Income gain was smaller (only $10,000 difference)?
- Total cost was larger ($160,000 tuition)?
Example: In numerical example, what if we tax labor by
taking 40% of output (worker keeps (.60)(total output))?
# Days
0
1
2
3
4
5
6
7
TB
0
36
63
84
99
108
114
117
Marg. Benefit
not defined
36
27
21
15
9
6
3
Marg. Cost
not defined
20 = 20-0
20 = 40-20
20 = 60-40
20 = 80-60
20 = 100-80
20 = 120-100
20 = 140-120
TC
0
20
40
60
80
100
120
140
 Best level is now 3 days worked => individual works
less, since the tax made the gain from working smaller
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Importance of “Incentive Principle” to “Public Policy”:
 Direct impact of many “government policies” is to alter
costs and benefits => as a result, individual behavior will
often change, so that the impact of the policy is NOT
exactly what might have been expected or intended
Example:
 Increased automobile safety requirements enacted
starting in 1960’s (e.g., padded dashboards, seat belts,
collapsible steering columns, etc.)
 Intended to make automobile transportation safer (one
observable outcome: reduce number of deaths to drivers)
 Sam Peltzman (University of Chicago) found there was
essentially no change in number of accidental deaths to
drivers after the regulations were enacted
 Why didn’t the number of driver deaths decrease?
 “Safer car” reduces the “cost of fast/reckless driving”
(e.g., playing with radio, talking on cell phone, etc.)
 Drivers “applied Cost-Benefit Principle” and chose to
drive “faster and more recklessly” in their “safer cars”
 Peltzman found that after the regulations, there were
i. fewer “deaths per accident” (as a result of cars
being “safer”), but
ii. more accidents (as people changed their driving
behavior)
 Two effects were of “relatively equal magnitude” and
“cancelled each other out” => essentially no change in
the number of accidental deaths to automobile drivers
 “Unintended Side Effect”: there was an increase in
number of deaths to pedestrians (who, after all, get no
benefit from padded dashboards and seatbelts)
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Do you find it hard to believe that people would really
“choose” to “increase the likelihood of an accident” by
driving “faster and more recklessly” in a “safer car”?
 i.e., that people would voluntarily “tradeoff” the “cost
of an accident” against the “benefits of driving faster
and/or paying less attention to the road”…
Recognize that one way to “restate this observation” is to
note that it simply implies that people would “drive more
cautiously” in a car that is “more dangerous.”
Consider the following “hypothetical automobile safety
feature” [suggested by Armen Alchian (UCLA) and
Gordon Tullock (Geroge Mason University)]:
 Install a sharp, irremovable, foot long, iron spike to
the steering wheel of every car, aimed right at the
driver’s heart.
 What would be the effect of this “safety feature” on
the number of automobile accidents?
 If you had such a spike in your car, would you drive
80 mph and tailgate the car in front of you while
talking on your cell phone?
So, are “automobile safety features” a “good thing”?
 Yes, but not just since they “make cars safer,” but also
since they “let us drive faster and more recklessly.”
Main point: direct impact of many “government policies” is
to alter costs and benefits => behavior often changes, so
that the impact is NOT exactly what was intended.
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The recognition that people are self-interested…
Self-Interested Individual – someone who makes his own
personal assessment of the benefits and costs associated
with different outcomes, and who subsequently uses these
measures as the basis for decision making
 by definition, a self-interested person places more weight
on his own priorities than on the priorities of others
 further, most people care much more about their own
well-being than they care about the well-being of others
Consider the following scenario (modified from Adam
Smith’s The Theory of Moral Sentiments (1759)):
A.
B.
C.
D.
You cut off the tip of your pinky finger.
Your favorite sports team gets eliminated from the
playoffs.
Your favorite entertainer dies unexpectedly.
A tsunami in Myanmar kills 1,000 people.
 When you get home your best friend calls. You say,
“I have horrible news, ___________________.”
 Focusing on “A” doesn’t mean that you are a “bad
person,” it just means that you are a person => People
are Self-Interested.
 James Miller (Game Theory at Work (2003)) and Arthur
Brooks (Who Really Cares (2006)) quote Mel Brooks:
“Tragedy is [if] I cut my finger. Comedy is if you fall
into an open manhole and die.”
 To say a person is Self-Interested does NOT mean that
the person cares ONLY about himself. Rather, it simply
recognizes that he cares more about himself (and those
close to him) than he cares about most other people.
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