Chapter 1
The nature and method
of economics
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
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Learning objectives
• Is the study of economics of consequence
or importance?
• What is the methodology of economics? In other
words, how should we study economics? What
are the proper methods by which the study of
economics is best achieved?
• What specific problems, limitations and pitfalls
can we encounter in studying economics?
• What characterises or identifies an ‘economic
perspective’?
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The roles of economics
• Economics is concerned with the efficient use
of limited productive resources for the purpose
of attaining the maximum satisfaction of our material
wants
• Why study economics? John Maynard Keynes
offered this response:
‘The ideas of economists and political philosophers, both when
they are right and when they are wrong, are more powerful than
is commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from
any intellectual influences, are usually the slaves of some
defunct economist.’
Keynes, 1936
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The age of the economists
•
•
•
•
•
•
Adam Smith
David Ricardo
John Stuart Mill
Karl Marx
Jon Maynard Keynes
Plus many modern contributors
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The roles of economics
• Economics for citizenship
– To create well-informed members of society
• Economics in business
– To provide business with strategic information
and interpretations
• Personal applications
– To assist individuals, as workers and income
receivers,
to gain and retain economic security
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PPTs t/a Macroeconomics by Jackson and McIver
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Methodology of economics
• What do economists do? What are their goals? What methods
do they use?
– Economists derive economic principles that are
useful in formulating policies designed to solve
economic problems
• The methods used by economists are:
1. Facts — descriptive or empirical economics
concerned with gathering facts relevant to an
economic problem
2. Principles or theories — economists generalise about
economic behaviour formulating economic theory
3. Policies — formulating policies for correcting the
problem
under scrutiny called applied economics
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Induction and deduction
• Induction
– A method of reasoning that proceeds from facts
to generalisations
• Deduction
– Reasoning from assumptions to conclusions
by testing a hypothesis
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Descriptive economics
• Complex in economics unlike physical sciences
– Economics is a social science involving the
complexities of individuals and institutions
– Facts are difficult to gather and interpret
– Economists must use discretion in collecting data, and
must distinguish economic from non-economic facts
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Economic theory
• Facts must be arranged systematically,
interpreted and generalised to derive
appropriate economic theory
• Theories or principles are the end result
of economic analysis. These are meaningful
statements drawn from facts
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Terminology of economic theory
• Economists use the terms ‘laws',' principles’,
‘theories’ and ‘models’ to represent generalisations,
or statements of regularity, concerning the economic
behaviour of
individuals and institutions
• A model is a simplified picture of reality, an abstract
generalisation of how the relevant
data actually behave
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Generalisations in economics
• Economic principles are generalisations,
and subject to exceptions and to quantitatively
imprecise statements
• Economic principles are often stated in terms
of averages or statistical probabilities
• Generalisations, properly handled and
interpreted, can be both meaningful
and useful
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Economic theory
• The ‘other things being equal’ assumption
– The process of analysis, that all other variables,
other than the one being considered are constant,
often referred to as ceteris paribus
• Abstractions in economics
– Economic theories do not encompass the full
complexity of reality
– An economic model enables us to understand reality
because it avoids the details of reality
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Microeconomics
and macroeconomics
• Macroeconomics deals with the economy as
a whole, or with the basic subdivisions or aggregates
that make up the economy
– An aggregate is a collection of specific economic
units that are treated as if they were one unit
• Microeconomics is concerned with specific economic
units and a detailed consideration
of the behaviour of these individuals units
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Policy economics: positive
and normative
• Positive economics deals with facts (and theories about
these facts) and avoids value judgments. Attempts to set
out scientific statements about economic behaviour
• Normative economics are based upon someone’s value
judgments about what the economy should be like or what
particular policy action should be recommended, based on
a given economic generalisation or relationship. It embodies
subjective feeling about ‘what ought to be’
– Normative economic statements come into play at
the level
of policy economics
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Economic goals
1. Economic growth
2. Full employment
3. Economic efficiency
4. Price-level stability
5. Economic freedom
6. An equitable distribution of income
7. Economic security
8. External balance
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Economic goals (cont.)
• Interpretation
– The basic economic goals inevitably entail problems
of interpretation — what are ‘sizeable’, ‘high degree’
and ‘equitable’?
• Complementary goals
– Some of the goals are complementary
• Conflicting goals
– Many goals are conflicting or mutually exclusive,
and involve trade-offs
• Priorities
– When goals conflict, society has to prioritise
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Formulating economic policy
Three basic steps in policy formulation:
1. Stating goals
– Define the goals clearly
2. Policy options
– State and recognise the possible effects of alternative
policies designed to achieve the goal
3. Evaluation
– Review the policies and evaluate their effectiveness
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
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Pitfalls to objective thinking
•
•
•
•
Bias
Loaded terminology
Definitions
Fallacy of composition
– What is true for the individual or part is not
necessarily true for the group or whole
• Cause and effect
– Post-hoc fallacy
– Correlation versus causation
• Economic quackery
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The economic perspective
• Scarcity and choice
– Resources are limited and this necessitates choices
• Rational behaviour
– Behaviour that involves decisions and actions in order
to achieve the greatest satisfaction or maximum
fulfilment of goals
– People will make different choices, because their
circumstances, preferences and available
information differ
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
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The economic perspective (cont.)
• Marginalism: benefits and costs
– Decision that compares marginal benefits and
marginal costs
– Incremental benefits available from any changes
are compared to the incremental costs of making
the change
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
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Graphs and their meaning
Appendix to Chapter 1
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
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Constructing a graph
• Two-dimensional graph
– Horizontal axis representing independent variable
– Vertical axis representing dependent variable
– Intersection (0) is origin
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Direct and indirect relationships
• Graphing relationships between variables
– Direct relationship
where the values of two related variable change
in the same direction e.g. consumption and income
– Inverse relationship
where the values of two related variables move in
opposite directions e.g. ticket prices and
attendance
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
1-23
Direct relationship
As Y increases, C increases
Consumption (C)
$500
$400
C = 50 + 0.5Y
$300
Consumption
e
d
$200
c
b
$100
0
a
$100
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
$200
$300
$400
Income (Y)
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Inverse relationship
$25
As P increases, Q decreases
a
Ticket Price (P)
b
P = 25 – 1.25Q
$20
c
$15
d
$10
Ticket demand
e
$5
f
0
4
8
12
16
Attendance in thousands (Q)
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1-25
Dependent and independent
variables
• Dependent variable
– The variable which changes as a consequence
of a change in some other (independent) variable
• Independent variable
– The variable which causes a change in some
other (dependent) variable
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Other variables held constant
• When economists plot the relationship between any
two variables, they assume that ‘other things being
equal’; that is, all other factors that might affect
consumption, are presumed to be constant
or unchanged
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Slope of a straight line
• The ratio of the vertical change (the rise or fall)
to the corresponding horizontal change involved
in moving between two points
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Positive slope
Consumption (C)
$500
vertical change
 50
Slope 

 0.5
horizontal change  100
$400
C = 50 + 0.5Y
$300
Consumption
e
d
$200
c
vertical change = +50
b
$100
a
horizontal change = +100
o
$100
$200
Copyright  2007 McGraw-Hill Australia Pty Ltd
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$300
$400
Income (Y)
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Negative slope
Ticket price (P)
$25
a
vertical change
5
Slope 

 1.25
b horizontal change  4
$20
P = 25 – 1.25Q
c
–5
$15
+4
d
$10
e Ticket demand
$5
f
0
4
8
12
16
Attendance in thousands (Q)
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Slope of a line
Three addenda
• Measurement units
– The slope of a line is affected by the choice of units
for either variable
• Marginal analysis
– The slope of a line measures marginal changes
• Infinite and zero slopes
– Variables that are unrelated or independent of one
another will be represented by a line parallel to the
vertical or horizontal axis, and will have a slope of
infinity or zero, respectively
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Slope of a line (cont.)
• Intercept
– The vertical intercept is the point at which the line
meets the vertical axis
• Equation form
– Linear equation
y = a + bx
where: y = the dependent variable
a = the vertical intercept
b = the slope of the line
x = the independent variable
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Slope of a non-linear relationship
or curve
Y
Tangent
a
A
P
a
A
X
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Slope of a curve (cont.)
Y
40
30
b
P
20
10
b
0
10
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20
30
40
X
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