The Nature and Method of Economics

Chapter 1

The Economic Perspective

Economics has a number of key concepts:

– Scarcity and choice

– Rational behavior

– Marginalism

Scarcity and Choice

Economists believe that:

– Resources are limited

– Material wants are unlimited

– Therefore society must choose where and how to spend these limited resources.

Rational behavior

Economists believe that human behavior reflects rational self-interest. Rational behavior is when:

– People try to increase their utility (pleasure, satisfaction).

– People try to decrease their disutility (pain, dissatisfaction).

Rational behavior

Economists believe that people maximize their utility in a completely rational and logical fashion.

Marginalism

Economists focus on marginal analysis:

Marginal analysis is the comparison of marginal benefits and marginal costs.

Marginalism

Marginal benefit is the additional or extra benefit that is the result of a choice.

Marginal cost is the additional or extra cost that is the result of a choice.

Economic Perspective

Economists believe that people compare the marginal benefits with the marginal costs whenever they make a decision; that they do so rationally; and that their decisions are to maximize their utility.

Scientific Method

• Recognize

• Assume

• Develop

• Hypothesize

• Test

Scientific Method: Recognize

• Recognize the problem or

• Identify an issue

Scientific Method: Assume

• Make a series of simplifying assumptions to manage the problem.

Scientific Method: Develop

• Use the assumptions to create a model

Scientific Method: Hypothesize

• Out of the model create an hypothesis.

• Use the hypothesis to solve the problem.

Scientific Method: Test

• Collect your data.

• Test your hypothesis against the data.

Ceteris Paribus

• Defined as:

• ALL OTHER THINGS BEING EQUAL

Ceteris Paribus

• This means holding everything else constant, except for the variables in our hypothesis or model.

• If we hold everything else constant, we hold it fixed.

• If we hold it fixed, we can ignore it.

Ceteris Paribus

• Ceteris paribus is a key assumption, because it allows us to treat everything outside of our model as unimportant.

Fallacy of Composition

• Beware of fallacy of composition!

• Fallacy of composition is the idea that what is good for one person (or part) is good for everyone (or the whole).

Post Hoc Fallacy

• One needs to think very carefully in order to decide whether something is the cause of something else.

Correlation vs. Causation

• Beware of the difference between correlation and causation:

• Correlation is coincidence.

• Causation is X causes Y.

Positive vs. Normative Analysis

• Be aware of the difference between positive and normative approaches!

• Positive analysis is an attempt to do value free analysis of an economic issue.

• Normative analysis is analysis with openly stated values.

Economics

• There are two main branches of economics:

– Macroeconomics

– Microeconomics

Macroeconomics

Defined as:

The study of the economy as a whole, or major sectors of the economy.

Macroeconomics

• In macro, we study:

- Government policies

- Aggregate business behavior

- Aggregate consumer behavior

- Money and banking

Microeconomics

Defined as:

The study of decision making by firms, households and individuals.

Microeconomics

• In micro, we study:

- How prices are formed.

- How much is to be produced.

- Individual behavior in the marketplace.

- The application of economic logic to a variety of contemporary problems.