Lecture 1
What is Economics?
What is Economics?
Readings: Chapter 1
What is Economics?
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It is a social science concerned with understanding
the forces that shape social values and social
behaviour.
By understanding these forces, economists hope to
better understand why social values and social
behaviours change, and the implications of such
changes.
What is Economics?
What is Changing?
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Over the last 200 years, science, economic growth,
and the forces of globalization have dramatically
transformed prices, laws, social norms and other
social values.
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The international market place has created local markets and
has created a common set of world prices
Global private corporations emerged to organize
extraordinarily complex production processes that straddle the
earth.
Representative democracy was invented and is spreading
fast.
Government expenditures on public services have grown
faster than most economies.
These changing social values are profoundly changing
the social behaviour of human beings.
What is Economics?
How can we investigate human social values and social
behaviour?
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Theory
Empirical evidence.
Biologists already do this with bees and other species.
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http://www.youtube.com/watch?v=VsCmSWoF8PY&feature=related
Both Bees and humans are social animals. Why cannot
human social values and social behaviours best
understood as biological systems?
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http://www.earthcam.com/usa/newyork/timessquare/
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http://www.youtube.com/watch?v=MODmEMm1Ql8&feature=related
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A crucially important difference is that bees are
governed by a biological instinct to perform a community
function. Instead of instinct, humans are motivated by
individual values (wants) as well as social values.
What is Economics?
Is it easy to discover the forces shaping
social values and social behaviour?
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Two common mistakes are often encountered
in trying to unlock truth:
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Post-Hoc Fallacy (post hoc ergo propter hoc)
Fallacy of Composition (What is true of part of the whole
must must be true of the whole). An economic example is
the famous Paradox of Thrift:
 A. If a household saves more money now, instead of
spending, it will have more money to spend in the
future.
 B. Therefore, if all households save more money now,
instead of spending, they will all have more money to
spend in the future.
What is Economics?
How can these fallacies be avoided?
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To avoid these mistakes, the physical
sciences employ controlled experiments.
In economics, such experiments are usually
too costly, too difficult, or immoral to
perform.
What is Economics?
To avoid errors in interpreting relationships,
economists rely heavily on developing economic
models:
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Theoretical models enable simple thought experiments
to replace controlled experiments.
Statistical models enable examination of the historical
record to isolate individual factors influencing social
outcomes.
The objective is to be able to identify how changing one
thing (independent variable) influences another
(dependent variable) while holding all other things
constant (ceteris paribus)
What is Economics?
Economic models are abstractions for examining the
social phenomenon of interest with the extraneous
detail cut-away to reveal underlying relationships
that would otherwise be hidden.
 Abstractions should be as simple as possible
(Ockham’s razor), but there is always a danger of
oversimplification.
 If these models are any good they will help us:
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better understand the workings of the social world around
us (Positive Economics)
design changes to our social world in order to make it a
better place (Normative Economics).
What is Economics?
Over time, two sorts of economic models have
developed to examine the forces behind the
formation of social values and social behaviour.
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Microeconomics (Fall Term) is primarily concerned with
how modern human social systems are organized. In
particular economists are very interested in how markets
work, the motivations and decisions of human institutions
(families, business, government), and how markets and
institutions interact with one another.
Macroeconomics (Winter Term) is primarily concerned
with the economy as a whole , and how the economy
moves through time (dynamics such as inflation,
economic growth, etc.).
What is Economics?
Where do all economic models begin?
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Economics is distinct from the other social sciences in
that it concerns itself with understanding the social
forces that stem from the problem of scarcity?
For economists, scarcity is the human existential
problem, and social values and social behaviour are a
response to this problem.
What is Economics?
What is the cause of scarcity?
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There are two causes:
1. Our finite world has limited resources.
2. Human nature tends towards unlimited wants.
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Without unlimited human wants scarcity
would not be a problem.
Can scarcity be defeated?
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No. Even the richest human beings
confront scarcity every day.
Attempts to moderate wants through moral
education have largely failed.
What is Economics?
How do human beings deal with scarcity?
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Humans attempt to as best they can by
1. Rational Choice
2. Investment
3. Social Cooperation.
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Economists believe that by understanding
rational choice, investment, and cooperation,
we can better understand the social forces
governing society.
What is Economics?
How do people make rational decisions?
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People try their best to choose a plan of action
which provides them with the best outcome
possible.
Very often the best plan of action is the one
which provides highest net benefit where:
Net Benefit = Benefit - Cost
What is Economics?
Example: How many hours should
you study in a 24 hour day?
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Identifying your best study strategy is a difficult
problem because to solve it directly we need to:
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Identify a function that translates all possible
strategies into a benefit payout.
Identify a function that translates all possible
strategies into an unavoidable cost.
Subtract the cost function from the benefit function to
derive the net benefit function.
Use calculus to find where the net benefit function is
maximized.
What is Economics?
Total Cost
Satisfaction
Net Benefit
Total Benefit
Study Hours
What is Economics?
What are the benefits and costs in this problem?
 The benefit of study includes satisfaction from
learning and the satisfaction from the
opportunities that learning may afford.
 The costs of study are all opportunity costs .
What is Economics?
What is an opportunity cost?
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When making choices all people face trade-offs.
Doing one thing means not doing something else.
The opportunity cost of something is what you give
up to get it.
The opportunity cost of study is the satisfaction
that could have been enjoyed in the next best
alternative use of that time.
With a little thought you can see that all economic
costs are in fact opportunity costs.
What is Economics?
Do people choose strategies in this way?
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No! Calculating a net benefit function is difficult.
Even if they could it is doubtful that many would use
calculus to find the maximum of this function.
Can experts provide advice on choosing an
optimal strategy for studying?
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No! Notice that the benefits and opportunity costs are
satisfaction – a purely subjective value.
Because the value of costs and benefits are subjective,
the optimal strategy can be expected to vary from person
to person.
What is Economics?
Does this mean people are too stupid to be
capable of rational choice?
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No! Economists have identified a secret algorithm that
allows even the dullest to choose rationally.
The secret algorithm is known to economists as the
principle of marginalism
What is Economics?
To see how marginalism works, consider our earlier problem of how
many hours to study. Instead of asking what the optimal strategy
is, ask the simpler question of whether the benefits from the
additional hour (marginal benefit) from study outweigh the costs
of the additional hour (marginal cost) from study.
Algorithm: Principle of Marginalism
 If the marginal benefit exceeds the marginal cost from an
additional hour of studying, then it is rational to increase your
activity (studying).
 If the marginal cost exceeds the marginal benefit from an
additional hour of studying, then it is rational to reduce your
activity (studying).
 Continue adjusting your activity until marginal benefit equals
marginal cost.
What is Economics?
Total Cost
Satisfaction
Net Benefit
Total Benefit
H0
H*
H1
Study Hours
What is Economics?
How do humans invest when confronted by scarcity?
 Investment is a two-step process in which:
i) current consumption is sacrificed (saved)
ii) savings are used to construct tools (invest) that
expands human power over the world
 Examples:
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Sacrifice wheat consumption to increase seed
Sacrifice profits to build a new machine
Sacrifice income to acquire knowledge
What is Economics?
How much should a person invest?
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Investment is most effective when combined with
rational decision-making.
Rational investors will direct their investments so
that the net benefit from their scarce investment
funds will be maximized.
According to the principle of marginalism:
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Invest in a particular activity whenever the marginal benefit
exceeds the marginal cost of the investment.
Invest up to the point where the marginal benefit just
equals the marginal costs.
What is Economics?
How do humans cooperate when confronted by
scarcity?
 Construct Institutions
1. Families (households)
2. Governments
3. Private Enterprise (firms)
 Participate in Markets where they can enter
into voluntary agreements to exchange goods
and services that make both better off.
What is Economics?
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Because of scarcity, Institutions (families, firms and
governments) use rational decision-making and
investment to efficiently employ their scarce
resources in a manner which best promotes their
interests.
All institutions engage with each other through
markets. For example:
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A family enters the housing market to buy a house. The
size of this investment is rationally chosen to best promote
the interests of the family. They enter the financial capital
market to get a mortgage loan sufficient to buy the house.
To pay for the interest on their loan, household members
sell their labour in the labour market.
What is Economics?
An economy is defined by the mixture of
institutions and markets that has been
adopted to organize cooperation.
A society’s economy determines:
 What is produced
 How it is produced
 Who receives what is produced (Distribution)
What is Economics?
Do humans always cooperate in the
same way?
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Hunter gatherer economies (Families are
Dominant Institution)
Feudal economies (The State is the Dominant
Institution)
Centrally planned or command economies (The
State is the Dominant Institution)
Capitalist economies (The Market Is the
Dominant Institution)
Mixed economies (Markets and Democratic
Government Dominate to Varying Degrees)
What is Economics?
Humans have invented many different types of
economies to foster cooperation.
 No economy has defeated scarcity.
 No amount of science and economic growth will
ever defeat scarcity so long as humans remain
insatiable.
 The idealism in socialist and green political
philosophy often hinges on the creation of a new
sort of human being that does not suffer from greed.
 Economists are deeply sceptical.
What is Economics?
What kind of economy does Canada have?
 Canada has a mixed economy in which markets
organize most economic activity, yet governments
intervene with command mechanisms to alter
market outcomes.
 For example, the government of Canada
expropriates income using taxation and uses this
revenue to:
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fund public services that might not be available in the
market and to
fund transfers to the poor.
What is Economics?
Canada’s economy is also an open economy in which
Canadian households and firms are connected to
households and firms throughout the world by
international markets.
Globalization has increased the degree of openness
and has fostered the development of transnational
institutions:
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Multinational Corporations
United Nations
World Bank / International Monetary Fund/Kyoto / WTO /
etc.
Two Big Economic Questions
Some economic questions to consider:
1. How does our mixed economy work?
2. Can it be reorganized to make our society better?
3. Does further globalization help or hurt our society?
4. Can we respond positively to the challenges of
global warming, natural resource depletion,
widespread poverty in the developing world, …
5. What does the economic rise of India and China
mean for Canadian society?