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Economics and Economics and Economic ReasoningEconomic Reasoning

Chapter 1Chapter 1

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What Economics IsWhat 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 IsWhat 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 IsWhat 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 IsWhat 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 IsWhat 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 IsWhat 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 A Guide to Economic ReasoningReasoning Economic reasoning is making

decisions by comparing costs and benefits.

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Marginal Costs and Marginal Costs and Marginal BenefitsMarginal 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 Costs and Marginal BenefitsMarginal Benefits In economists’ jargon, marginal refers to

additional or incremental. Think of it as one more.

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Marginal Costs and Marginal Costs and Marginal BenefitsMarginal 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 Costs and Marginal BenefitsMarginal Benefits Marginal benefit = the additional

benefit above and beyond what you’ve already accrued.

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Marginal Costs and Marginal Costs and Marginal BenefitsMarginal 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 CostOpportunity 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 CostOpportunity Cost

In economic reasoning, opportunity cost must be less than the benefit of the choice you have made.

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Opportunity CostOpportunity Cost

Opportunity costs are not limited to individual decisions but to government decisions as well.

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Opportunity CostOpportunity 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 Economics and Market ForcesForces When goods are scarce, they must be

rationed. Rationing is a mechanism chosen to

determine who gets what.

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Economic InsightsEconomic 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 InsightsEconomic Insights

Theory ties together economists’ terminology and knowledge about economic institutions and leads to economic insights.

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Economic InsightsEconomic 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 InsightsEconomic 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 InsightsEconomic Insights

Theories, and the models and principles used to represent them, are abstract but efficient, means of conveying information.

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Economic InsightsEconomic Insights

In order to understand the theory you must understand the assumptions underlying the theory.

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The Invisible Hand The Invisible Hand TheoryTheory 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 The Invisible Hand TheoryTheory 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 Microeconomics and MacroeconomicsMacroeconomics Economic theory is divided into two

parts: microeconomics and macroeconomics.

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MicroeconomicsMicroeconomics

Microeconomics is the study of individual choice, and how that choice is influenced by economic forces.

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MicroeconomicsMicroeconomics

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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MicroeconomicsMicroeconomics

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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MicroeconomicsMicroeconomics

Microeconomics analyses from the parts to the whole.

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MacroeconomicsMacroeconomics

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 InstitutionsEconomic 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 InstitutionsEconomic Institutions

In applying economic theory to reality, you must know about economic institutions.

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Economic Policy Economic Policy OptionsOptions Economic policies are actions taken

by government to influence economic actions.

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Economic Policy Economic Policy OptionsOptions 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 Objective Policy AnalysisAnalysis 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 Objective Policy AnalysisAnalysis 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 Objective Policy AnalysisAnalysis 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 Objective Policy AnalysisAnalysis Normative economics is the study of

what the goals of the economy should be.

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Objective Policy Objective Policy AnalysisAnalysis 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 Objective Policy AnalysisAnalysis 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 Objective Policy AnalysisAnalysis Maintaining objectivity is easier in

positive economics – harder in normative economics.

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Objective Policy Objective Policy AnalysisAnalysis 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 Objective Policy AnalysisAnalysis 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 Economics and Economic ReasoningEconomic Reasoning

End of Chapter 1End of Chapter 1