CH1 What is economics?
I.
Definition of Economics
A. Economic questions arise because we face scarcity—we all want more than we can get.
1.
Because we are unable to satisfy all of our wants, we must make choices.
2.
Incentives are the rewards that encourage us, or the penalties that discourage us, from
taking an action. The incentives that we face will influence the choices that we make
when dealing with scarcity.
B. Economics is the social science that studies the choices that individuals, businesses,
governments, and societies make as they cope with scarcity. It can be divided into two areas
of study:
1.
Microeconomics is the study of the choices individuals and businesses make, the way
those choices interact in the markets, and the influence of governments.
2.
Macroeconomics is the study of the performance of the national economy and the
global economy.
II. Two Big Economics Questions
A. The first big question is “How do choices end up determining what, how and for whom are
goods and services produced?
1.
What goods and services are produced in our economy?
a)
Goods and services are the objects that people value and produce to satisfy
human wants.
b) Figure 1.1 shows the trends
in what the U.S. economy
has produced over the past
60 years. It shows the
decline of agriculture,
mining, construction, and
manufacturing goods, and
the expansion of services.
2.
How are goods and services
produced?
a)
Factors of production
are the productive resources
used to produce goods and
services. These include
land (natural resources),
labor (the work time and
work effort of people),
capital (tools, instruments,
and machines that are used
to produce goods and
services), and
entrepreneurship (the
human resource that
organizes land, labor, and
capital).
b) The quality of labor
depends on human
capital, which is the
knowledge and skill that
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people obtain from education, work experience, and on-the-job training. Figure 1.2
shows how the level of human capital (measured by educational attainment) in the
United States has increased over the past century.
3.
For whom are goods and services produced?
a)
Who gets to consume the goods and services that are produced depends on the
incomes that people earn.
b) Owners of the factors of production earn income, which is a monetary return for
using the resources for production: Land earns rent, labor earns wages, capital
earns interest, and entrepreneurship earns profit.
c)
In the United States, labor earns the largest share of all income (70 percent), but this
income is not distributed equally across the population.
B. The second big question is “When is the pursuit of self-interest also in the social interest?”
1.
People make choices in their own self-interest—they make choices they think are best
for their own well-being.
a)
The incentives surrounding an individual’s choice amongst available alternatives
influence the tradeoffs involved in making that choice.
b) The choice made by one individual changes the incentives surrounding the tradeoffs
facing other individuals, which influences their choices.
c)
2.
In this way, many self-interested individuals making choices in society will bring
about change to the incentive surrounding all decisions to be made by individuals in
the economy.
When people make self-interested choices that are the best for society, they make choices
that are considered in the social interest.
a)
In 1776 Adam Smith published The Wealth of Nations describing how a market
based system can theoretically motivate self-interested individuals to make choices
that promote the social interest.
b) Economists try to identify those characteristics of a market system that successfully
promote self-interested individuals to make choices that coincide with the social
interest.
3.
We can examine a number of current events to determine whether self-interested
individuals made choices in the social interest:
a)
Privatization: The fall of socialism and the rise of capitalism in Europe
b) Globalization: The local impact of growing international trade
c)
The “New” Economy: Workers adjusting to changing technologies
d) The post 9-11 economy: Terror changes vacation habits
e)
Corporate scandals: Preventing stealing by corporate officials through lying
f)
HIV/AIDs: Poorest countries hit hardest but lack medicines
g) Disappearing tropical rainforests: Lack of property rights creates waste
h) Water shortages: Consumers fail to pay the opportunity cost of consumption
i)
Unemployment: Persistence in minority teenage unemployment
j)
Deficits and Debt: Having future generations pay for today’s services
WHAT IS ECONOMICS?
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IV. The Economic Way of Thinking: Choices and Tradeoffs
A. Because we all face scarcity, we all must make choices between available alternatives—
which creates a tradeoff.
1.
A tradeoff is an exchange—giving up one thing to get something else.
2.
“Guns versus Butter” is a classic tradeoff that every country faces when deciding how
much of its factors of production should go towards producing national security versus
goods and services like food and shelter.
B. What, How, and For Whom Tradeoffs
C.
1.
“What?” Tradeoffs arise when people choose how to spend their incomes, when
governments choose how to spend their tax revenues, and when businesses choose what
to produce with their factors of production.
2.
“How?” Tradeoffs arise when businesses and governments choose among alternative
production technologies. For example: businesses might switch to using robotics rather
than labor in assembly lines, thereby effectively trading off labor for capital.
3.
“For Whom?” Tradeoffs arise when choices change the distribution of goods and
services produced across individuals. Government redistribution of income from the rich
to the poor changes the incentives facing owners of productive resources, creating the
Big Tradeoff: the tradeoff between efficiency and equity.
The results arising from all the choices made in society will influence the incentives
surrounding the future choices by other people, businesses, and governments. For example:
1.
Consumers’ decisions to consume less and save more increases the funds that are
available for businesses to borrow and invest, increasing future output.
2.
Workers’ decision to decrease leisure time to acquire human capital increases their
income as well as government income tax revenues, increasing how much public services
the government chooses to offer.
3.
Businesses’ decisions to increase research and development for innovative products
rather than to increase current production improves investor’s expectations, increasing
the level of income people invest (save).
D. Thinking about a choice as a tradeoff emphasizes how cost is an opportunity forgone.
1.
Opportunity cost is the highest-valued alternative that we give up to get something.
2.
The opportunity cost of attending college includes not only the money cost of books,
tuition and (perhaps) room and board, but also the money income forgone from not being
able to work full time, as well as the leisure time lost from studying nights and weekends.
E. People make choices at the margin. Making choices at the margin means people look at
tradeoffs that arise from making small changes in an activity.
1.
The benefit that arises from an increase in an activity is its marginal benefit.
2.
The opportunity cost of an increase in an activity is its marginal cost.
3.
Marginal benefit and marginal cost act as an incentive influencing people’s
choices.
a)
If the marginal benefit of an alternative exceeds the marginal cost, people have an
incentive to do more of that activity.
b) If the marginal cost of an alternative exceeds the marginal benefit, people have an
incentive to do less of that activity.
F.
A change in the incentives people face changes the choices they make.
1.
Economists can predict how people will choose based on understanding the incentives
they face.
1.
When the incentives facing the individual are in the social interest, their choices will
promote the social interest.
2.
When people make choices that are not in the social interest, they do so because they
face the wrong incentives.
V. Economics is a Social Science
A. Economists distinguish between two types of statements about the world:
1.
Positive statements make a claim about “what is” and can be tested to determine whether
they are valid.
2.
Normative statements make a claim of “what ought to be.” Such a statement is an
opinion and cannot be tested for validity.
B. Economists build models
1.
Economists observe and measure economic activity, build economic models, and test
their models.
2.
An economic model is a description of some aspect of the economic world that
includes only those features of the world that are needed for the purpose at hand.
C. Economists test their models
1.
An economic theory is a generalization that summarizes what we think we understand
about the economic choices that people make and the performance of industries and
entire economies.
D. Obstacles and Pitfalls in Economics
1.
Ceteris Paribus means “other things being equal.” Economists try to isolate causeand-effect relationship by changing only one variable at a time, and hold all other
relevant factors unchanged.
2.
The Fallacy of Composition is the (false) statement that what is true for the parts is true
of the whole or that what is true for the whole is true of the parts.
3.
The Post Hoc Fallacy gets its name from the Latin term “Post hoc, ergo propter
hoc,” which means “after this, therefore, because of this.” This fallacy is (false)
claim that a first event causes a second event because the first occurred before
the second.
E. Agreement and Disagreement
1.
Economists are often accused of contradicting each other. In contrast to the
popular image, economists find much common ground on a wide range of
issues. (Page X lists twelve different economic propositions that at least 70
percent of all economists polled will agree upon.)
WHAT IS ECONOMICS?
Chapter 1 Appendix, Graphs in Economics
Outline
I.
Graphing Data
A. Graphs are valuable tools that clarify what otherwise might be obscure relationships.
B. Graphs represent “quantity” as a distance. Two-variable graphs use two
perpendicular scale lines. The vertical line is the y-axis. The horizontal line is the xaxis. The zero point in common to both axes is the origin.
C. Three types of graphs are
1.
Time-series graph—a graph that plots time along the x-axis and the variable
being studied along the y-axis. A time-series graph shows the level of the
variable, how it changes over time, whether changes are rapid or slow, and
whether there is any trend.
2.
Cross-section graph—a graph that plots the values of a variable for
different groups at the same point in time.
3.
Scatter diagram—a graph that plots the value of one variable on the x-axis
and the value of the associated variable on the y-axis. A scatter diagram can
make clear the relationship between two variables.
II. Graphs Used in Economic Models
A. Graphs are used to show the relationship between variables.
B. Graphs can immediately convey the relationship between the variables:
1.
2.
3.
A positive relationship (or direct relationship)—when the variable on the
x-axis increases the variable on the y-axis increases. A straight line is a linear
relationship.
A negative relationship (or inverse relationship)—when the variable on
the x-axis increases, the variable on the y-axis decreases.
A maximum or a minimum—when the variable has a highest or lowest value.
III. The Slope of a Relationship
A. The slope of a curve equals the change in the value of the variable on the vertical
axis at the point where the slope is being calculated divided by the change in the
value of the variable on the horizontal axis at the relevant point.
1.
In terms of symbols, the slope equals y/x, with  standing for “change in.”
B. The slope of a straight line is constant. The slope is positive if the variables are
positively related and negative if the variables are negatively related.
C. The slope of a curved line at a point equals the slope of the straight line that is
tangent to the curved line at the point.
D. The slope of a curved line across an arc equals the slope of the straight line between
the two points on the curved line.
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IV. Graphing Relationships Among More Than Two Variables
A. When a relationship involves more than two variables, we can plot the relationship
between two of the variables by holding other variables constant.