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Economic Theory

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The Role of Theory1. Economists develop theories, or models, to help

explain economic behavior. 2. An economic theory is a simplification of economic

reality that is used to make predictions about the real world, such as what happens to the consumption of Pepsi when its cost increases.

3. To help develop theory, economists make simplifying assumptions. One category of this is the other things constant assumption. This involves identifying and focusing on a variable and assumes nothing else of importance changes.

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The Role of Theory (continued)4. Economists also make assumptions about what

motivates people – how people behave. These are called behavioral assumptions.

5. The most basic behavioral assumption is that people make choices based on self-interest.

6. Rational self interest means that you try to maximize the expected benefit achieved with a given cost, or to minimize the expected cost of achieving a given benefit.

7. Rationality implies that each consumer buys the products expected to maximize his or her level of satisfaction and that each firm supplies the products expected to maximize that firms profit.

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Normative vs. Positive

8. A positive economic statement is a statement about economic reality that can be supported or rejected by reference to the facts.

9. A normative economic statement reflects someone’s opinion.

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Marginal Analysis 10.Marginal means incremental, additional,

extra or one more. 11.A rational decision maker will change the

status quo as long as the expected marginal benefit from the change exceeds the expected marginal cost.

12.Rational choice takes time and requires information.

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Market Economics and National Economics

13.Microeconomics focuses on your economic behavior and the economic behavior of others who make choices involving what to buy and sell. Microeconomics is another term for market economics.

14.Macroeconomics focuses on the performance of the economy as a whole, especially the national economy. Macroeconomics is another term for national economics.

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Market Participants

15. There are four types of decision makers in the economy– 1. businesses– 2. government – 3. households– 4. the rest of the world

16. Households play the leading roel in the economy.17. Markets are the means by which buyers and sellers

carry out exchange.