Economics and Economic
Reasoning
Chapter 1
© 2003 McGraw-Hill Ryerson Limited.
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What Economics Is

Economics is the study of how human
beings coordinate their wants and
desires, given the decision-making
mechanisms, social customs, and
political realities of the society.
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What Economics Is

Three central coordination problems
any economic system must solve are:
 What,
and how much, to produce.
 How to produce it.
 For whom to produce it.
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What Economics Is

Scarcity ensues because individuals
want more than can be produced.
 Scarcity
– the goods available are too few
to satisfy individuals’ desires.
 Wants are unlimited, but resources are
limited
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What Economics Is
The degree of scarcity is constantly
changing.
 The quantity of goods, services, and
usable resources depends on
technology and human action.

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What Economics Is

The following are the five important
things to learn in economics:
 Economic
reasoning.
 Economic terminology.
 Economic insights economists have about
issues, and theories that lead to those
insights.
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What Economics Is

The following are the five important
things to learn in economics (cont’d):
 Information
about economic institutions
 Information about the economic policy
options facing society today.
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A Guide to Economic
Reasoning

Economic reasoning is making
decisions by comparing costs and
benefits.
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Marginal Costs and Marginal
Benefits

The relevant costs and benefits to
economic reasoning are the expected
incremental or additional costs incurred
and the expected incremental or
additional benefits of a decision.
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Marginal Costs and Marginal
Benefits

In economists’ jargon, marginal refers to
additional or incremental.
 Think
of it as one more.
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Marginal Costs and Marginal
Benefits

Marginal cost = the additional cost to
you over and above the costs you have
already incurred.
 This
means eliminating sunk costs – costs
that have already been incurred and cannot
be recovered.
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Marginal Costs and Marginal
Benefits

Marginal benefit = the additional
benefit above and beyond what you’ve
already accrued.
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Marginal Costs and Marginal
Benefits

According to the economics decision
rule:
 If
the marginal benefits of doing something
exceed the marginal costs, do it.
 If the marginal costs of doing something
exceed the marginal benefits, don’t do it.
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Opportunity Cost

Opportunity cost – the basis of
cost/benefit economic reasoning; it is a
cost of the activity you have chosen
measured by the benefit foregone of the
next-best alternative.
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Opportunity Cost

In economic reasoning, opportunity cost
must be less than the benefit of the
choice you have made.
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Opportunity Cost

Opportunity costs are not limited to
individual decisions but to government
decisions as well.
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Opportunity Cost

The opportunity cost concept applies to
all aspects of life and is fundamental to
understanding how society reacts to
scarcity.
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Economics and Market Forces

When goods are scarce, they must be
rationed.
 Rationing
is a mechanism chosen to
determine who gets what.
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Economic Insights

General insights into how economies
work are often based on economic
theory.
 Economic
theory – generalizations about
the workings of an abstract economy.
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Economic Insights

Theory ties together economists’
terminology and knowledge about
economic institutions and leads to
economic insights.
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Economic Insights

Because theories are too abstract to
apply to specific cases, a theory is often
embodied in an economic model or an
economic principle.
 Economic
model – a framework that places
the generalized insights of the theory in a
more specific contextual setting.
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Economic Insights

Because theories are too abstract to
apply to specific cases, a theory is often
embodied in an economic model or an
economic principle.

Economic principle – a commonly held
insight stated as a law or general
assumption.
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Economic Insights

Theories, and the models and principles
used to represent them, are abstract but
efficient, means of conveying
information.
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Economic Insights

In order to understand the theory you
must understand the assumptions
underlying the theory.
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The Invisible Hand Theory

The invisible hand theory states that
markets are efficient in coordinating
individuals’ decisions, allocating scarce
resources to their best possible use.
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The Invisible Hand Theory

This insight is called the invisible hand
theory – a market economy through the
price mechanism will allocate resources
efficiently.
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Microeconomics and
Macroeconomics

Economic theory is divided into two
parts: microeconomics and
macroeconomics.
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Microeconomics

Microeconomics is the study of
individual choice, and how that choice is
influenced by economic forces.
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Microeconomics

Microeconomic theory considers
economic reasoning from the viewpoint
of individuals and firms and builds up
from there to an analysis of the entire
economy.
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Microeconomics

Microeconomics studies such things as:
pricing policy of firms, households’
decisions on what to buy, and how
markets allocate resources among
alternative ends.
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Microeconomics

Microeconomics analyses from the
parts to the whole.
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Macroeconomics
Macroeconomics is the study of
inflation, unemployment, business
cycles, and economic growth.
 Macroeconomics analyzes from the
whole to the parts.

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Economic Institutions
Corporations, governments, and cultural
norms are all economic institutions.
They differ significantly among nations.
 Economic institutions sometimes seem
to operate in ways quite different than
economic theory predicts.

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Economic Institutions

In applying economic theory to reality,
you must know about economic
institutions.
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Economic Policy Options

Economic policies are actions taken
by government to influence economic
actions.
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Economic Policy Options

Those who wish to carry out economic
policy effectively must understand how
institutions might change as a result of
the economic policy.
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Objective Policy Analysis
Good objective policy analysis keeps
the value judgments separate from the
analysis.
 Subjective policy analysis is that which
reflects the analyst’s view of how things
should be.

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Objective Policy Analysis

In order to make the distinction between
objective and subjective analysis clear,
economists have divided economics
into three categories.
 Positive
economics
 Normative economics
 Art of economics
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Objective Policy Analysis

Positive economics is the study of
what is, and how the economy works.
 Examples
include: how does the stock
market work, what are the consequences of
rent control on the market for housing, and
are the costs of having children related to
family income?
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Objective Policy Analysis

Normative economics is the study of
what the goals of the economy should
be.
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Objective Policy Analysis

Normative economics is the study of
what the goals of the economy should
be.
 Examples
include: people on welfare
should work in order to get benefits,
inherited wealth should be taxed more
heavily, and corporations should not be
allowed to move their facilities overseas
unless it is agreed to by labor unions.
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Objective Policy Analysis

Art of economics is the application of
the knowledge learned in positive
economics to the achievement of the
goals determined in normative
economics.
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Objective Policy Analysis

Maintaining objectivity is easier in
positive economics – harder in
normative economics.
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Objective Policy Analysis

It is hardest to maintain objectivity in the
art of economics since it embodies the
problems of both positive and normative
economics.
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Objective Policy Analysis

One of the best ways to find out about
feasible economic policy options is to
compare them from one country to
another.
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Economics and Economic
Reasoning
End of Chapter 1
© 2003 McGraw-Hill Ryerson Limited.