Ch01-7e

WHAT IS ECONOMICS?1CHAPTER

ObjectivesAfter studying this chapter, you will be able to:Define economics and distinguish between microeconomics and macroeconomicsExplain the big questions of economicsExplain the key ideas that define the economic way of thinkingExplain how economists go about their work as social scientists

Understanding Our Changing WorldYou are studying economics at a time of enormoud change.Some of the change is for the betterthe information age and all the benefits that it brings.Some of the change is for the worseterrorism and recession send shockwaves through our lives.Your economics course will help you to understand the powerful forces that are shaping and changing our world.

Definition of EconomicsAll economic questions arise because we want more than we can get.Our inability to satisfy all our wants is called scarcity.Because we face scarcity, we must make choices.The choices we make depend on the incentives we face.An incentive is a reward that encourages or a penalty that discourages an action.

Definition of EconomicsEconomics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile those choices.

Definition of EconomicsMicroeconomicsMicroeconomics is the study of choices made by individuals and businesses, and the influence of government on those choices.MacroeconomicsMacroeconomics is the study of the effects on the national and global economy of the choices that individuals, businesses, and governments make.

Two Big Economic Questions Two big questions summarize the scope of economics: How do choices end up determining what, how, and for whom goods and services get produced? When do choices made in the pursuit of self-interest also promote the social interest?

Two Big Economic Questions What, How, and For Whom?Goods and services are the objects that people value and produce to satisfy wants.What?What we produce changes over time.Sixty years ago, almost 25 percent of Americans worked on farms: Today that number is 3 percent.Today, almost 80 percent of Americans provide services.

Two Big Economic QuestionsFigure 1.1 shows the trends in what the U.S. economy has produced over the past 60 years. It shows the decline of agriculture, mining, construction, and manufacturing, and the expansion of services.

Two Big Economic QuestionsThe facts about what we produce raise the deeper question: What determines the quantities of realtor services, new homes, DVD players, and corn that we produce?Economics provides some answers to these questions.

Two Big Economic QuestionsHow?Goods and services are produced by using productive resources that economists call factors of production.Factors of production are grouped into four categories: Land Labor Capital Entrepreneurship

Two Big Economic QuestionsThe gifts of nature that we use to produce goods and services are land.The work time and effort that people devote to producing goods and services is labor.The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, on-the-job training, and work experience.

Two Big Economic QuestionsThe tools, instruments, machines, buildings, and other constructions that are used to produce goods and services are capital.The human resource that organizes land, labor, and capital is entrepreneurship.

Two Big Economic QuestionsFigure 1.2 shows a measure of the growth of human capital in the United States over the last centurythe percentage of the population that has completed different levels of education.

Two Big Economic QuestionsThe facts about how we produce raise the deeper question: What determines the quantities of capital, labor, and other resources that get used to produce goods and services?Economics provides some answers to this question.

Two Big Economic QuestionsFor Whom?Who gets the goods and services depends on the incomes that people earn. Land earns rent. Labor earns wages. Capital earns interest. Entrepreneurship earns profit.

Two Big Economic QuestionsWhen is the Pursuit of Self-Interest in the Social Interest?Every day, 6.3 billion people make economic choices that result in What, How, and For Whom goods and services get produced.Do we produce the right things in the right quantities?Do we use our factors of production in the best way?Do the goods and services go the those who benefit most from them?

Two Big Economic QuestionsYou make choices that are in your self-interestchoices that you think are best for you.Choices that are best for society as a whole are said to be in the social interest.Is it possible that when each one of us makes choices that are in our self-interest, it also turns out that these choices are also in the social interest?

Two Big Economic QuestionsTen issues in todays world illustrate the importance of this question: Does public ownership and central planning do a better job than private business and free markets? Is globalization a benefit or a problem? Do the technological advances in the new economy bring benefits to all? How did 9/11 change our economic lives?

Two Big Economic Questions Dont corporate scandals show that big business works against the social interest? Should drug companies be forced to make HIV/AIDS drugs available to poor people at a low cost? Are we destroying our tropical rain forests? Are the worlds water resources being managed properly? Are there enough jobs? Are we all (individuals, businesses, and governments) borrowing too much and creating too much debt?

The Economic Way of ThinkingChoices and TradeoffsThe economic way of thinking places scarcity and its implication, choice, at center stage.You can think about every choice as a tradeoffan exchangegiving up one thing to get something else.The classic tradeoff is guns versus butter.Guns and butter stand for any two objects of value.

The Economic Way of ThinkingWhat, How, and For Whom TradeoffsThe questions what, how, and for whom become sharper when we think in terms of tradeoffs.What? Tradeoffs arise when people choose how to spend their incomes, when governments choose how to spend their tax revenues, and when businesses choose what to produce.

The Economic Way of ThinkingHow? Tradeoffs arise when businesses choose among alternative production technologies.For Whom? Tradeoffs arise when choices change the distribution of buying power across individuals. Government redistribution of income from the rich to the poor creates the big tradeoffthe tradeoff between equality and efficiency.

The Economic Way of ThinkingChoices Bring ChangeWhat, how, and for whom goods and services get produced changes over time and the quality of our economic lives improve.But the quality of our economic lives and the rate at which they improve depends on choices that involve tradeoffs.We face three tradeoffs between enjoying current consumption and leisure time and increasing future production, consumption, and leisure time.

The Economic Way of ThinkingIf we save more, we can buy more capital and increase our production.If we take less leisure time, we can educate and train ourselves to become more productive.If businesses produce less and devote resources to research and developing new technologies, they can produce more in the future.The choices we make in the face of these tradeoffs determine the pace at which our economic condition improves.

The Economic Way of ThinkingOpportunity CostThinking about a choice as a tradeoff emphasizes cost as an opportunity forgone.The highest-valued alternative that we give up to get something is the opportunity cost of the activity chosen.

The Economic Way of ThinkingChoosing at the MarginPeople make choices at the margin, which means that they evaluate the consequences of making incremental changes in the use of their resources.The benefit from pursuing an incremental increase in an activity is its marginal benefit.The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.

The Economic Way of ThinkingResponding to IncentivesOur choices respond to incentives.For any activity, if marginal benefit exceeds marginal cost, people have an incentive to do more of that activityIf marginal cost exceeds marginal benefit, people have an incentive to do less of that activity.Incentives are also the key to reconciling self-interest and the social interest.

The Economic Way of ThinkingHuman Nature, Incentives, and InstitutionsEconomists take human nature as given and view people as acting in their self-interest.Self-interested actions are not necessarily selfish actions.But if human nature is given and people pursue self-interest, how can the social interest be served?Economist answer this question by emphasizing the role of institutions in creating incentives to behave in the social interest.Paramount: the rule of law that protects private property and facilitates voluntary exchange in markets.

Economics: A Social ScienceSocial scienceEconomics is a social science.Economists distinguish between two types of statement:What ispositive statementsWhat ought to benormative statementsA positive statement can be tested by checking it against factsA normative statement cannot be tested.

Economics: A Social ScienceSocial scienceThe task of economic science is to discover positive statements that are consistent with what we observe in the world and that enable us to understand how the economic world works.This task is large and breaks into three steps: Observation and measurementModel buildingTesting models

Economics: A Social ScienceObservation and MeasurementEconomists observe and measure economic activity, keeping track of such things as: Quantities of resources Wages and work hours Prices and quantities of goods and services produced Taxes and government spending Quantities of goods and services bought from and sold to other countries.

Economics: A Social ScienceModel BuildingAn economic model is a description of some aspect of the economic world that includes only those features of the world that are needed for the purpose at hand.

Economics: A Social ScienceTesting ModelsAn economic theory is a generalization that summarizes what we think we understand about the economic choices that people make and the performance of industries and entire economies.A theory is a bridge between a model and reality. It is a proposition about which model works.

Economics: A Social ScienceObstacles and Pitfalls in EconomicsEconomists cannot easily do experiments and most economic behavior has many simultaneous causes.To isolate the effect of interest, economists use the logical device called ceteris Paribus or other things being equal.Economists try to isolate cause-and-effect relationship by changing only one variable at a time, holding all other relevant factors unchanged.

Economics: A Social ScienceObstacles and Pitfalls in EconomicsTwo common fallacies that economists try to avoid are:The fallacy of composition, which is the false statement that what is true for the parts is true for the whole or what is true for the whole is true for the parts.The post hoc fallacy from the Latin term Post hoc, ergo propter hocmeans after this, therefore because of this, which is the error of reasoning that a first event causes a second event because the first occurs before the second.

Economics: A Social ScienceAgreement and DisagreementEconomists are often accused of contradicting each other.In contrast to the popular image, economists find much common ground on a wide range of issues.Page 14 of the textbook lists twelve economic propositions that at least 70 percent of all economists polled agreed on.

THE END

No definition of economics can adequately capture the subject. For that reason, some teachers dont like definitions and skip right over them. If you are one of these teachers, go ahead. Not much is lost.Other teachers regard a basic definition as essential, and the textbook takes this view. The definition in the textthe social science that studies the choices that individuals, businesses, and governments, and entire societies make as they cope with scarcity, is a modern language version of Lionel Robbins famous definition, Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.Some teachers like to play with definitions a bit more elaborately. If you are one of these, here are four more, all of which add some useful insight and the last one a bit of fun:John Maynard Keynes: 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 the mind, a technique of thinking, which helps it possessors to draw correct conclusions.Alfred Marshall: Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.Jacob Viner: Economics is what economists do.Jim Duesenberry: Economics is all about how people make choices. Sociology is about why there isnt any choice to be made.No definition of economics can adequately capture the subject. For that reason, some teachers dont like definitions and skip right over them. If you are one of these teachers, go ahead. Not much is lost.Other teachers regard a basic definition as essential, and the textbook takes this view. The definition in the textthe social science that studies the choices that individuals, businesses, and governments, and entire societies make as they cope with scarcity, is a modern language version of Lionel Robbins famous definition, Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.Some teachers like to play with definitions a bit more elaborately. If you are one of these, here are four more, all of which add some useful insight and the last one a bit of fun:John Maynard Keynes: 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 the mind, a technique of thinking, which helps it possessors to draw correct conclusions.Alfred Marshall: Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.Jacob Viner: Economics is what economists do.Jim Duesenberry: Economics is all about how people make choices. Sociology is about why there isnt any choice to be made.Dont skip the questions in a rush to get to the economic way of thinking. Open your students eyes to economic in the world around them. Ask them to bring a newspaper to class and to identify headlines that deal with stories about What, How, and For Whom. Use Economics in the News Today on your Parkin Web site for a current news item and for an archive of past items (with questions). Pose questions and be sure that the students appreciate that they will have a much better handle on questions like these when theyve completed their economics course.Talk about Adam Smith and the Wealth of Nations.Note that this book was the first systematic attempt to address this big question and that economists have been trying to answer it ever since.You might like to mention that several Nobel Prizes have been awarded to economists who have worked on the question including Ken Arrow, John Hicks, and Gerard Debreu, as well as John Nash of Beautiful Mind fame.There is not much that we can say to our students at this early point in the course about the way we try to answer this big question. But we can raise the interest level and excitement about the economics course by talking about issues like the 10 listed on page 5 of the textbook.Talk about some of these and any others that you happen to know a decent amount about. Try very hard to turn your students on! Get them debating these issues and try to steer the discussion toward benefits, costs, and who receives and bears them. There is not much that we can say to our students at this early point in the course about the way we try to answer this big question. But we can raise the interest level and excitement about the economics course by talking about issues like the 10 listed on page 5 of the textbook.Talk about some of these and any others that you happen to know a decent amount about. Try very hard to turn your students on! Get them debating these issues and try to steer the discussion toward benefits, costs, and who receives and bears them. Begin by encouraging the students to use the economic way of thinking to reflect on their own lives.Why are you here in college? Ask the students why they are pursuing a university degree. Most of them will say that they want a good paying job. Tell them about jobs such as postal workers, long haul truck drivers or grocery clerks that require relatively little training and offer up to $30,000 a year plus benefits. Ask the students to calculate the opportunity cost of being in school. Most students are shaken when they realize that the opportunity cost of a college degree approaches $150,000 to $200,000. Dont leave them hanging here though. Mention that a college education does yield a high rate of return and suggest that they study Reading Between the Lines (pp. 4647) when they get through Chapter 2.Will your tradeoffs improve? You can do your students a further favor by helping them to realize that the tradeoffs they face today are as favorable as they will ever be. Its an old clich, but effective, to remind them that they are not going to be any more attractive than they are now, nor are they going to gain any additional physical prowess or have any greater capacity to learn than they have at this very moment in their lives. Right now they could do almost anything they set their minds to do. Encourage the students to figure out and be utterly convinced that the benefits they receive from being in college exceed the large opportunity cost that scarcity forces them to bear. Remind them of the relevance of this cost benefit calculation to their decisions to skip classes, not studying for exams, or retake core courses and delay graduation.Scarcity Versus Poverty Ask the students why they havent yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty. You can emphasize this distinction.

Who shall live and who shall die? Moving from personal to social decisions, use a no-win situation that is of major social importance. Such situations show with stark clarity that scarcity is just as important an issue as poverty. A good example comes from the development of new medical treatments. Every societyeven the richestfaces a tradeoff between making new, promising medicines available quickly while assuring that they are also safe. That is why the Food and Drug Administration (FDA) is charged with assessing both the efficacy as well as the safety of each new drug before it is released to the market. Patients who are HIV positive, or who have Alzheimers disease or suffer from many types of cancer all require immediate access to the latest, promising medicines in order to have a chance for survival. But without thorough and time-consuming testing procedures, the safety of new drugs is not known. So we must choose between two bad outcomes: 1) lives lost because people take promising drugs that turn out to have unforeseen deadly side-effects, or 2) lives lost because people are denied access to promising drugs until sufficient testing can be performed to check that they are both effective and safe. Regardless of which drug distribution policy we adopt, many people will die. Although depressing, this realty check illustrates drives home the deadly seriousness of the phrase: There is no such thing as a free lunch.

The value of models. Help the students to appreciate the power of models as tools for understanding reality. The analogy of a model as a map is easy and convincing. Jim Peach, a fine economics teacher at the University of New Mexico, gets his students to make paper airplanes on the first day of class. After flying their paper planes around the classroom (and picking up the debris!) he gets them to talk about what they can learn about real airplanes from experimenting with paper (and other model) planes.The success of a model is judged by its ability to predict. Help your students appreciate that no matter how appealing or realistic looking a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable. Milton Friedmans pool hall example illustrates the point nicely. Imagine a physicists model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving tangents, cosigns and a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It wouldnt depict what we seea pool stick striking a pool cue on a rectangular patch of green felt. It wouldnt even reflect the thought processes of the pool shark, who relies on years of experience and the right touch. But constructed correctly, this mathematical model would predict exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can invent analogous examples from any sport.)