Econ Chapter 01

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McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

ECONOMICSAND

ECONOMIC

REASONING

Chapter 1


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Todays lecture will:

Define economics.

Examine three coordination problems all economies mustsolve.

Compare marginal costs and marginal benefits to makedecisions.

Define and explain opportunity costs.

Explain how economic, social, and political forces influencereal-world events.

Distinguish between:

microeconomics and macroeconomics.

positive economics, normative economics, and the artof economics


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What Economics Is

Economics is the study of how human beings coordinatetheir wants and desires, given the decision-makingmechanisms, social customs, and political realities of thesociety.

Coordination problem in Economics:

Any economic system must solve three coordinationproblems:

What, and how much, to produce.

How to produce it. For whom to produce it.


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The Economic Problem

SCARCITY exists because individuals want more than can beproduced. The goods available are too few to satisfy individualsendless desires (I think this is too controversial!)

Scarcity has two elements: our wantsand our means of fulfillingthese wants.

If I work on Wall Street, Ill probably want upscale and trendyclothes. But here, in Atilim University, Im quite happy wearing jeansand t-shirt.

As you see, wants are changeable and determined by the society.

The degree of scarcity is constantly changing.

The quantity of goods, services, and usable resources depends on

technology and human action which underlie the production.

Degree of imagination, technology, innovativeness and enthusiasmscan increase available goods and resources.

All of these would not eliminate the scarcity entirely since newwants are developing.


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Economic Reasoning, or how economists think?

Economists are trained to put their emotions aside and focus on

the costs and benefits. They are simply amoral (not believing in orcaring for morality and immorality).

How economists evaluate, for instance, the policy options to eliminatethe terrorist attacks on the airlines?

They just argue the issue in terms of costs & benefits (cost / benefit

approach).

Economic reasoning also involves abstracting from theunimportant elements of a question and focusing on theimportant ones.

By collecting empirical evidences

Testing the models (matching the predictions of the model with theempirical evidence) to see if it is fits.

In brief, economic reasoning means to make decisions on thebasis of costs and benefits This is the way economists think.


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Continued ATTENTION: Economic reasoning will, definitely, not provide

all the answers. Because, real world questions are much more

complicated. This way of thinking will simply provides aframework within which to approach a question.

Within this framework, we have reached such a conclusionthat every choice has costs and benefits and decisions aremade by comparing them. It is an economistic reasonable-

ness that you may not like too much. Think about possibilitiesbelow:

May be we shouldnt try to eliminate all pollution, because the

additional cost of doing so may be too high. To eliminate allpollution might be to forgo too much of some other worthwhile

activity. It might make sense for automobile industry to save $12 per car

by not installing safety device, even though without it somepeople will be killed.

Does this seem cold-hearted? Then, just have a look at

following story:

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7/23McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Excerpt From The Corporation: The PathologicalPursuit of Profit and Power by Joel Bakan

Patricia Anderson was driving home from midnight mass, her four

children in the backseat of her 1979 Chevrolet Malibu car. Shestopped at a red light, and as she waited for it to change, a carslammed into the back of her car, causing it to burst into flames.children were burned over 60 percent of their bodies, and one ofthem had to have her hand amputated. () She sued General Motors,

blaming the company for the explosion and fire. The fuel tank on herMalibu, her lawyers argued, had been insufficiently protected fromthe impact of the collision. After a lengthy trial the jury found thatGM had dangerously positioned the fuel tank to save costs. () Theevidence in the trial showed that General Motors had been aware of

the possibility of fuel-fed fires when it had designed the Malibu andsome of its other models as well. () GM management asked anengineer from the company's Advance Design department, EdwardC. Ivey, to analyze fuel-fed fires in GM vehicles. He submitted hisreport, "Value Analysis of Auto Fuel Fed Fire Related Fatalities,"shortly thereafter

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Continued

() In the report, Ivey multiplied the five hundred fuel-fed fire

fatalities that occurred each year in GM vehicles by $200,000, hisestimate of the cost to GM in legal damages for each potentialfatality, and then divided that figure by 41 million, the number ofGM vehicles operating on U.S. highways at the time. Heconcluded that each fuel-fed fatality cost GM $2.40 perautomobile. The calculation appeared like this in thememorandum: 500 fatalities x $200,000 / fatality 41,000,000automobiles = $2.40/automobile The cost to General Motors ofensuring that fuel tanks did not explode in crashes, estimated bythe company to be $8.59 per automobile , meant the companycould save $6.19 ($8.59 minus $2.40) per automobile if it allowed

people to die in fuel-fed fires rather than alter the design ofvehicles to avoid such fires. (pp.62-3).

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The Economic Decision Rule

In economic reasoning decisions are often made by comparingmarginal costs and marginal benefits.

Relevant costs and relevant benefits are the expected marginal (i.e.,incremental) costs and benefits.

Marginal cost the additional cost over and above costs alreadyincurred; that is, not including sunk costs(costs that have alreadybeen incurred and cannot be recovered). [Batk maliyetler]

Your tuition is a sunk cost; therefore, marginal (or additional)cost of going to class does not include it.

Marginal benefit the additional benefit above and beyond whathas already accrued.

If the marginal benefits of doing something exceed the marginalcosts, do it.

If the marginal costs of doing something exceed the marginalbenefits, dont do it.



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Opportunity Cost

So, why some are dealing drugs and not working in a legal job?(see Steve Levitts Freakonomics)

The potential financial benefit of selling drugs is much higher thanthe cost of giving up a minimum wage job.

This brings us to the concept of the opportunity cost which is the

basis of cost / benefit economic reasoning. DEFINITION: To obtain the benefit of something, you must give

up (forgo) something else. So, opportunity cost is the benefitforgone of the next-best alternative to the activity you havechosen.

Opportunity cost should always be less than the benefit of whatyou have chosen.

Please read the very interesting conversation taking place betweenProf. Colander and one of his students (at page 7).



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Examples of Opportunity Costs

Individual decisions

The opportunity cost of college includes: Items you could have purchased with the money spent for

tuition and books

Loss of the income from a full-time job

Also Note that, opportunity cost notion is applicable not only to

individual decisions, but also business and governmentdecisions as well.

Government decisions

The opportunity cost of money spent on the war on terrorismis less spending on health care or education.

Examples are endless



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Economics and Market Forces

The opportunity-cost concept applies to all aspects of life; its

fundamental to understanding how society reacts to scarcity. When goods are scarce, those goods must be rationed

(taynlama). A mechanism must be chosen to determine who gets

what. All scarce goods must be rationed in some fashion.

These rationing mechanisms are examples of economic

forces asthe necessary reactions to scarcity

For instance, a market force is an economic forcethat is givenrelatively free rein by society to work through the market.Market forces ration by changing prices.

The invisible hand is the price mechanism and the rise and fall ofprices that guides individual decisions in a market.

Shortages price goes up.

Surpluses price goes down.



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Continued

Sometimes complex social and cultural norms limit our economicactivities.

Exp. Saturday nights access supply

Sometimes existing political and legal forces squash the invisiblehand and limit the economic activities:

Exp. Delivering mail in your neighborhood to make some money(National Postal Service has a legal exclusive right to deliver regularmail, so youll be prohibited from delivering.

Often (formal and informal) political and social forces often worktogether against the invisible hand and prevent economic forcesfrom becoming market forces.

You can not buy or sell the babies

You can not practice medicine without license You can not sell body parts or certain addictive drugs

But, you may sell alcohol if you have a permit

You dont charge your friends interest to borrow money (youd losefriends)

You dont charge your children for their food, etc

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Economic Insights

Economic theory: generalizations about the workings of anabstract economy.

The theory ties together economists terminology and knowledge

about economic institutions and leads to economic insights.

In order to understand the theory, you must understand the

assumptions underlying the theory.

Economic model: A framework that places the generalizedinsights of theory in a more specific contextual setting, or in aneconomic principle, a commonly held insight stated as a law orgeneral assumption.

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

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The Invisible Hand Theory

According to the invisible hand theory, a market economy,through the price mechanism, will allocate resourcesefficiently.

Price has a tendency to fall when the quantity supplied isgreater than the quantity demanded.

Price has a tendency to rise when the quantity demandedis greater than the quantity supplied.

Efficiency means achieving a goal as cheaply as possible.

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Microeconomics and

Macroeconomics Economic theory is divided into two

parts: microeconomic theory andmacroeconomic theory.

Microeconomics is the study of individualchoice, and how that choice is influenced

by economic forces. Macroeconomics is the study of the

economy as a whole.

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Microeconomics and

Macroeconomics Microeconomics studies such things as:

the pricing policy of firms.

Households decisions on what to buy. how markets allocate resources among alternative

ends.

Macroeconomics deals with:

inflation.

unemployment.

economic growth.

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Economic Institutions

Economic institutions laws, commonpractices, and organizations in a

society that affect the economy. They sometimes seem to operate

differently than economic theorypredicts.

Economic institutions differsignificantly among nations.

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Economic Policies

Economic policies are actions (orinactions) taken by government to

influence economic actions. Objective policy analysis keeps value

judgments separate from the analysis.

Subjective policy analysis reflects theanalysts view of how things should be.

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Policy Analysis

To distinguish between objective andsubjective analysis, economics is dividedinto three categories:

Positive economics the study of what is

Normative economics the study of what

should be Art of economics using the knowledge of

positive economics to achieve the goalsdetermined in normative economics

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Economics and Economic

Reasoning Summary In solving the economic problem of scarcity,

any economy must answer the questions what should be produced?

how should it be produced?

who should get it?

Economic reasoning compares marginalbenefits with marginal costs. Do something ifits marginal benefits > its marginal costs.

The opportunity cost of an activity is the benefityou would have gained from the next bestalternative.

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Economics and EconomicReasoning Summary

The market, which rations scarce resources bychanging prices, is efficient under certainconditions.

Economics can be divided into Microeconomics the study of individual choice

Macroeconomics the study of the economy as awhole

Economics can be subdivided into Positive economics the study of what is

Normative economics the study of what should be

The art of economics relating positive to normative

economics

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M G Hill/I i h b h ll ll h d

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Review Exercise 1-1Suppose that you are considering going to a concert. Tickets cost

$60. If you go to the concert, you will have to miss 4 hours of work,where you are making $10 an hour. What is your total opportunitycost of going to the concert measured in dollars given up?

The total opportunity cost of going to the concert is $100, $60 forthe ticket and $40 lost income from missing work.

Review Exercise 1-2Suppose that after studying 7 hours for an economics test, you areconfident that you know enough to make a B. However, if you study

one more hour instead of watching your favorite TV show, you willprobably improve your grade to an A. Identify the marginal costs andbenefits in this situation.

The marginal benefit is the improvement in your grade from a B to an A.The marginal cost is the hour of lost entertainment.

Econ Chapter 01

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