OverviewThe Economic Way of Thinking

The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of mind, a technique of thinking which helps its possessor to draw correct conclusions.

--John Maynard Keynes

• Voluntary trade can create wealth• Specialization and exchange promote

economic growth• Market prices signal relative scarcities and

coordinates the allocation of resources• Perfectly competitive markets are efficient

The essence of economics

• Wealth is whatever people value. • Value is in the eyes of the chooser.• Both traders increase their own wealth

by cooperating in an exchange.

Voluntary trade can create wealth!

Jack has an apple. He is willing to pay $1 for an apple, and $2 for a pear.Rose has a pear. She is willing to pay $1 for a pear, and $2 for an apple.Both of them are willing to trade with the other.Before trade, the total wealth is $2. After trade, the total wealth is $4.

Voluntary trade can create wealth!

• Where does the additional wealth come from?• Trade is a productive process.• Production is trying to add value to the input. • Jack uses an apple as input and obtains a pear

as output• Rose uses a pear as input and obtains an apple

as output

Voluntary trade can create wealth!

• Economics growth consists not in increasing the production of things, but in increasing the production of wealth.

• Trade is a process of creating wealth.

Voluntary trade can create wealth!

• Hence Voluntary exchange can benefit both parties. • If not, then neither party would participate in

the trade in the first place!

Voluntary trade can create wealth!

• This conclusion can be extended to social exchange, which gives rise to a famous theory in sociology –– social exchange theory.

• In a word, social exchange theory claims that, your decision to engage in social interactions with other people indicates that you can benefit from it (emotionally, mentally, spiritually, etc.) Otherwise, you would not engage in it in the first place!

Social Exchange can create wealth!

• Specialization = pursuit of one’s comparative advantage

• Specialization can expand production possibilities (wealth) by trading for something that is more costly to produce on their own

• Recall that economic growth is represented by the expansion of production possibilities

Specialization can promote economic growth!

Specialization can promote economic growth!

Specialization can promote economic growth!

PPFs without specialization and trade

Specialization can promote economic growth!

Suppose both specializeExchange of 3 Lager for 3 stout

Specialization can promote economic growth!

Each enjoys a combination that lies beyond original frontiers

Specialization can promote economic growth!

• People expect to enjoy greater wealth by specializing in activities in which they believe themselves to have a comparative advantage

• We often ask questions about our comparative advantages– “What major is best for me?”– “What opportunities will I enjoy after I graduate?”

Specialization can promote economic growth!

The Role of Market Prices

• The market is where supply meets demand• Scarcity is a relationship between desirability

and availability, or between demand and supply

• Market prices inform us of relative scarcities. • Prices convey useful information that

coordinates the allocation of resources

The Role of Market Prices

• In other words, price is the signal that helps people to determine their comparative advantages– Entrepreneurs use prices to determine what to

produce– Employees use wages to determine what job they

will take

The Role of Market Prices

• When price is higher than it is supposed to be (higher than the equilibrium price), a surplus occurs.

• A surplus informs the sellers that the production is overvalued

• They will cut off production and reallocate resources elsewhere.

The Role of Market Prices

• When price is lower than it is supposed to be (lower than the equilibrium price), a shortage occurs.

• A shortage informs the sellers that the production is undervalued

• They will reallocate resources from elsewhere and increase the production.

The Role of Market Prices

• Question: What happens to current price if some people know the price to increase in the future?

The Role of Market Prices

• Answer: Expectation of a rise in price will increase the demand and decrease the supply. A change in expectations about tomorrow’s price can alter today’s price (self-fulfilling prophecy)

• A rise in current price will help the consumers and producers (even those without the information that the price will rise in the future) to reallocate resources and hence prepare for the future.

The Role of Market Prices

Pakistan just had a bad harvest in wheat. Out of the goodness of our good heats, we want to help them.Question: Do you think it is wise to help them by sending them wheat?

The Role of Market Prices

• Answer: If we send them wheat, it will distort/depress the price of wheat in their domestic market.

• In the long run, this will prevent resources to be allocated for wheat production in Pakistan.

• It is better to help them with money, with which they can buy wheat either from US market or domestic market.

Perfectly Competitive Markets

• Economically efficient the additional benefits outweigh the additional costs

• Perfectly competitive market is efficient (total surplus is maximized).

Ask the Right Questions

Three guys go to a motel and get a room. The total charge is $30, and each guy pays $10. After they go to their room, the desk clerk realizes he over charged them. He forgot about the special rate of $25 tonight. The clerk can’t leave his desk, so he contacts the maid, gives her five $1 bills, and asks her to go to the room and reimburse the three guys.

Ask the Right Questions

On her way, the maid wonders how she can divide $5 among three people. She decides, since they aren’t aware of the overcharge anyway, to give them $3 back and secretly pocket the remaining $2. No one will be any the wiser.

Ask the Right Questions

Now for the brainteaser: Each guy paid, in effect, $9: 3 times 9 equals 27. And the maid pocketed $2, for a total of $29. But the three guys originally paid $30, not $29.

Where did the other dollar go?

Ask the Right Questions

• It is nonsensical to ask “Where did the other dollar go?” because there is no answer to that question

• The right question “Where did the rest of the overpayment go?”

• Economics gives you with the ability to see through the nonsense.

Ask the Right Questions

• When evaluating an economic policy, we should pay more attention to the unintended consequences, instead of the motives

• What are the motives?

• Think outside the box. Don’t get confused by the motives

• What are the unintended consequences?

Unintended Consequences

• We cannot assume people behave the same way facing in a new situation

• Enforcement of a policy changes people’s incentives, which results in unintended consequences that are not expected by the policy-makers

Rent control: Goal

• Make sure low-income people may get cheap rent

• Reduce their living expenses

Rent control: Unintended Consequences

• Lots of people cannot find an apartment to live. People resort to other ways to compete for available apartments (long lines, reading obituary, bribery, etc.)

• Landlords have little incentive to maintain quality. Landlords will discriminate using non-price criteria

• The low price cannot attract people to construct new rental units

Rent control: Let the market work

• When the price is allowed to fluctuate, increased price will attract resources to be used to build new rental units to be built

Agricultural Price Support: Goal

• Protect family farmers• Without the price support, family farmers will

be driven out of market due to economic losses caused by high production cost

Agricultural Price SupportUnintended consequences

• Create economic profits for corporate farms with lower production costs

• Profits attract outsiders to bid for farmland and increase the price of farmland

• Higher cost of land increases production cost– For owners of farmland, economic losses is

mitigated by the greater implicit value of their land;– For many farm families who rent their land, there is

no such compensation

Agricultural Price SupportLet the Market Work

• The market price should have informed the family farmers to reallocate resources where they are more highly valued

Minimum Wage

• Goal: protect unskilled workers• Unintended consequences: Unemployment.

Especially for those with low skills.

Unintended Consequences

• Economics was christened “the dismal science” because its analysis frustrated so many hope and desires.

• On the other hand, knowing what is not possible can spare us many disappointments and avoid many disasters.

The Role of Government

• Competitive markets are efficiency, so the government should keep economic intervention minimal for competitive market

• Then, what is the role of government?

Three conditions for economic efficiency

• Large numbers of buyers and sellers; no one party has the ability to manipulate the market (counterexample: monopoly)

• No externalities (counterexamples: pollution, education, public goods, common resources)

• Complete information available about the quality of the goods (counterexample: used car)

The Role of Government

• Government does have a role to play in the economic system

• E.g. protecting property rights, regulating monopoly and promoting competition, taxing pollution, subsidizing education, providing public goods, regulating the use of common resources, protecting the poor

• But controlling the market prices should be cautioned

Is Market Economy Perfect?

• Market economy is not perfect or all-wise• There are a lot of problems with this economic

system (e.g. inequality)• It is a mistake to contrast a less-than-ideal

situation with an ideal-but-unattainable situation.

Is Market Economy Perfect?

• Democracy is the worst form of government except all those other forms that have been tried from time to time. —Winston Churchill

• Market economy is the worst form of economic system except all those other forms that have been tried from to time.

Want to know more about economics?

• One of the best economic textbooks

• Insightful book with storytelling

• No complicated technical analysis or graphs

Want to know more about economics?

• Which is more dangerous, a gun or a swimming pool? A shark or a football?

• What do school teachers and sumo wrestlers have in common?

• How incentives work?

Want to know more about economics?

• Why do the keypads on drive-up cash machines have Braille dots?

• Why are round-trip fares from Orlando to Kansas City higher than those from Kansas City to Orlando?

• Cost-benefit analysis

Are people really rational?

• Behavioral Economics• How people really

make decisions?• We will see from the

book that people often make irrational decisions.

Beyond Economics: Can economics make

you happy?

Beyond Economics: Can economics make me happy?

• Economics investigates the allocation of scare resources

• It assumes available resources cannot satisfy wants, and there is always a tension between availability and desirability

Beyond Economics: Can economics make me happy?

• Happiness is getting what you want.• According to economics, people can never

satisfy, so we can never be happy…• But…• Wealth is whatever people value.• Value is in the eyes of the chooser.

Beyond Economics: Can economics make me happy?

• Buddha wanted nothing—and that’s pretty much what he got.

• Since he had found what he wanted, he became wealthy.

• And he was happy.

How to Become Happy?A word of wisdom…

• Desire everything. • Need nothing. • Choose whatever shows up.