The Scope and Method of Economics

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

The Scope and Method of The Scope and Method of EconomicsEconomics


The Study of EconomicsThe Study of Economics

• EconomicsEconomics is the study of is the study of how individuals and societies how individuals and societies choose to use the scarce choose to use the scarce resources that nature and resources that nature and previous generations have previous generations have provided.provided.


Why Study Economics?Why Study Economics?

• Probably the most important reason Probably the most important reason for studying economics is for studying economics is to learn to learn a way of thinking.a way of thinking.

• Three fundamental concepts:Three fundamental concepts:

• Opportunity costOpportunity cost

• MarginalismMarginalism, and, and

• Efficient marketsEfficient markets


Opportunity CostOpportunity Cost

• Opportunity costOpportunity cost is the best is the best alternative that we forgo, or give alternative that we forgo, or give up, when we make a choice or a up, when we make a choice or a decision.decision.

• Opportunity costs arise because Opportunity costs arise because time and resources are scarce. time and resources are scarce. Nearly all decisions involve trade-Nearly all decisions involve trade-offs.offs.


MarginalismMarginalism

• In weighing the costs and benefits of a decision, In weighing the costs and benefits of a decision, it is important to weigh only the costs and it is important to weigh only the costs and benefits that arise from the decision.benefits that arise from the decision.

• For example, when deciding whether to produce For example, when deciding whether to produce additional output, a firm considers only the additional output, a firm considers only the additionaladditional (or marginal cost), not the sunk cost. (or marginal cost), not the sunk cost.

• Sunk costsSunk costs are costs that cannot be avoided, are costs that cannot be avoided, regardless of what is done in the future, because regardless of what is done in the future, because they have already been incurred.they have already been incurred.


Efficient MarketsEfficient Markets

• An An efficient marketefficient market is one in which is one in which profit opportunities are eliminated profit opportunities are eliminated almost instantaneously.almost instantaneously.

• There is no free lunch! Profit There is no free lunch! Profit opportunities are rare because, at opportunities are rare because, at any one time, there are many any one time, there are many people searching for them.people searching for them.


More Reasons to Study EconomicsMore Reasons to Study Economics

• Economics involves the study of societal and Economics involves the study of societal and global affairs concerning resource allocation.global affairs concerning resource allocation.

• Economics is helpful to us as voters. Voting Economics is helpful to us as voters. Voting decisions require a basic understanding of decisions require a basic understanding of economics.economics.

• Money and financial systems are an important Money and financial systems are an important component of the economic system, but are not component of the economic system, but are not the most fundamental issue in economics.the most fundamental issue in economics.


The Scope of EconomicsThe Scope of Economics

• MicroeconomicsMicroeconomics is the branch of economics is the branch of economics that examines the functioning of individual that examines the functioning of individual industries and the behavior of individual industries and the behavior of individual decision-making units—that is, business firms decision-making units—that is, business firms and households.and households.

• MacroeconomicsMacroeconomics is the branch of economics is the branch of economics that examines the economic behavior of that examines the economic behavior of aggregatesaggregates— income, output, employment, and — income, output, employment, and so on—on a national scale.so on—on a national scale.


The Diverse Fields of EconomicsThe Diverse Fields of Economics

Examples of microeconomic and macroeconomic concernsExamples of microeconomic and macroeconomic concerns

ProductionProduction PricesPrices IncomeIncome EmploymentEmployment

MicroeconomicsMicroeconomics Production/Output Production/Output in Individual in Individual Industries and Industries and BusinessesBusinesses How much steelHow much steelHow many officesHow many officesHow many carsHow many cars

Price of Individual Price of Individual Goods and ServicesGoods and Services Price of medical Price of medical carecarePrice of gasolinePrice of gasolineFood pricesFood pricesApartment rentsApartment rents

Distribution of Distribution of Income and WealthIncome and Wealth Wages in the auto Wages in the auto industryindustryMinimum wagesMinimum wagesExecutive salariesExecutive salariesPovertyPoverty

Employment by Employment by Individual Individual Businesses & Businesses & IndustriesIndustriesJobs in the steel Jobs in the steel industryindustryNumber of Number of employees in a employees in a firmfirm

MacroeconomicsMacroeconomics National National Production/OutputProduction/Output Total Industrial Total Industrial OutputOutputGross Domestic Gross Domestic ProductProductGrowth of OutputGrowth of Output

Aggregate Price Aggregate Price LevelLevel Consumer pricesConsumer pricesProducer PricesProducer PricesRate of InflationRate of Inflation

National IncomeNational IncomeTotal wages and Total wages and salaries salaries

Total corporate Total corporate profitsprofits

Employment and Employment and Unemployment in Unemployment in the the EconomyEconomy Total number of Total number of jobsjobsUnemployment Unemployment raterate


The Method of EconomicsThe Method of Economics

• Normative economicsNormative economics, , also called policy also called policy economics, analyzes outcomes of economic economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and behavior, evaluates them as good or bad, and may prescribe courses of action.may prescribe courses of action.

• Positive economicsPositive economics studies economic studies economic behavior without making judgments. It behavior without making judgments. It describes what exists and how it works.describes what exists and how it works.


The Method of EconomicsThe Method of Economics

• Positive economics includes:Positive economics includes:

• Descriptive economicsDescriptive economics, which involves the , which involves the compilation of data that describe phenomena and compilation of data that describe phenomena and facts.facts.

• Economic theoryEconomic theory that involves building models of that involves building models of behavior. A theory is a statement or set of related behavior. A theory is a statement or set of related statements about cause and effect, action and statements about cause and effect, action and reaction.reaction.

• Empirical economicsEmpirical economics refers to the collection refers to the collection and use of data to test economic theories.and use of data to test economic theories.


Theories and ModelsTheories and Models

• A A theorytheory is a general statement of cause and is a general statement of cause and effect, action and reaction. Theories involve effect, action and reaction. Theories involve models, and models involve variables.models, and models involve variables.

• A A modelmodel is a formal statement of a theory. is a formal statement of a theory. Models are descriptions of the relationship Models are descriptions of the relationship between two or more variables.between two or more variables.

• Ockham’s razorOckham’s razor is the principle that irrelevant is the principle that irrelevant detail should be cut away. Models are detail should be cut away. Models are simplifications, not complications, of reality.simplifications, not complications, of reality.



• A A variablevariable is a measure that can change from is a measure that can change from observation to observation.observation to observation.

• Using the Using the ceteris paribus, ceteris paribus, or or all else equal, all else equal, assumptionassumption, economists study the relationship , economists study the relationship between two variables while the values of other between two variables while the values of other variables are held unchanged.variables are held unchanged.

• The ceteris paribus device is part of the process The ceteris paribus device is part of the process of abstraction used to focus only on key of abstraction used to focus only on key relationships.relationships.



• In formulating theories and models we must In formulating theories and models we must avoid two pitfalls:avoid two pitfalls:

• The The Post Hoc FallacyPost Hoc Fallacy: It is erroneous to believe that : It is erroneous to believe that if event A happened before event B, then A caused B.if event A happened before event B, then A caused B.

• The The Fallacy of CompositionFallacy of Composition: It is erroneous to : It is erroneous to believe that what is true for a part is also true for the believe that what is true for a part is also true for the whole. Theories that seem to work well when applied whole. Theories that seem to work well when applied to individuals often break down when they are applied to individuals often break down when they are applied to the whole. to the whole.


Economic PolicyEconomic Policy

Criteria for judging economic outcomes:Criteria for judging economic outcomes:

• EfficiencyEfficiency, or allocative efficiency. An efficient , or allocative efficiency. An efficient economy is one that produces what people want at economy is one that produces what people want at the least possible costthe least possible cost..

• EquityEquity, or , or fairness of economic outcomes.fairness of economic outcomes.

• GrowthGrowth, or , or an increase in the total output of an an increase in the total output of an economy.economy.

• StabilityStability, or the condition in which output is steady , or the condition in which output is steady or growing, with low inflation and full employment or growing, with low inflation and full employment of resources. of resources.


How to Read and Understand GraphsHow to Read and Understand Graphs

• Each point on the Cartesian Each point on the Cartesian plane is a combination of plane is a combination of (X,Y) values.(X,Y) values.

• The relationship between X The relationship between X and Y is causal. For a given and Y is causal. For a given value of X, there is a value of X, there is a corresponding value of Y, or corresponding value of Y, or X causes Y.X causes Y.


Reading Between the LinesReading Between the Lines

• A A lineline is a continuous string is a continuous string of points, or sets of (X,Y) of points, or sets of (X,Y) values on the Cartesian values on the Cartesian plane.plane.

• The relationship between X The relationship between X and Y on this graph is and Y on this graph is negative. An increase in the negative. An increase in the value of X leads to a value of X leads to a decreasedecrease in the value of Y, in the value of Y, and vice versa.and vice versa.


Positive and Negative RelationshipsPositive and Negative Relationships

A A downward-slopingdownward-sloping line describes a line describes a negative relationship negative relationship between X and Y.between X and Y.

An An upward-slopingupward-sloping line line describes a positive describes a positive relationship between X relationship between X andand Y.Y.


The Components of a LineThe Components of a Line

• The algebraic expression of The algebraic expression of this line is as follows:this line is as follows:

Y = a + bXwhere:where:Y = dependent variabledependent variableX = independent variableindependent variablea = Y-interceptY-intercept, or value of, or value of YY when when XX = 0. = 0.

b = slopeslope of the line, or the of the line, or the rate of change in rate of change in YY given a change in given a change in XX..

+ = positive relationshippositive relationship between between XX and and YY

b =Y

X

Y Y

X X

1 0

1 0


Different Slope ValuesDifferent Slope Values

b 5

1 00 5. b

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1 00 7.

b 0

1 00 b

1 0

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Strength of the Relationship BetweenStrength of the Relationship BetweenX and YX and Y

• This line is This line is relatively flatrelatively flat. . Changes in the value of X have Changes in the value of X have only a small influence on the only a small influence on the value of Y.value of Y.

• This line is This line is relatively steeprelatively steep. . Changes in the value of X have a Changes in the value of X have a greater influence on the value of greater influence on the value of Y.Y.


The Difference Between a Line and a CurveThe Difference Between a Line and a Curve

Equal increments in Equal increments in XX lead to diminished lead to diminished increases in increases in YY..

Equal increments in Equal increments in XX lead to constant lead to constant increases in increases in YY..


Interpreting the Slope of a CurveInterpreting the Slope of a Curve

• Graph A hasGraph A hasa positive and a positive and decreasing decreasing slope. slope.

• Graph B hasGraph B hasa negative a negative slope, then a slope, then a positive slope. positive slope.

• Graph C shows Graph C shows a negative and a negative and increasing increasing relationship relationship between between XX and and YY. .

• Graph D Graph D shows a shows a negative and negative and decreasing decreasing slope. slope.

The Scope and Method of Economics

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study economics economics

policy economics

branch of economics

economics isto

descriptive economics

study of economics economicsis

economic theories

models of behavior