Introduction

Rhesus monkeys are willing to forgo 10% of their

income of cherry juice to examine photos of leading
and attractive members of their group.
This behavior mirrors our willingness to purchase
celebrity magazines.
Nevertheless, economists who study making choices in
response to rewards or inducements, propose some are
willing to pay to be viewed by others as leading and
attractive members of our society.
What can economists tell us about why people purchase
items that attract attention such as flashy sports cars or
designer clothing?

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Learning Objectives

Discuss the difference between

microeconomics and macroeconomics
Evaluate the role that rational self-
interest plays in economic analysis
Explain why the study of economics
is a science
Distinguish between positive and
normative economics
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Chapter Outline

The Power of Economic Analysis

Defining Economics

Microeconomics versus Macroeconomics

The Economic Person: Rational Self-Interest

Economics as a Science

Positive versus Normative Economics

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Did You Know That ...

Six of seven main U.S. railroad lines

meet in Chicago?
The bottlenecks these lines caused
created incentives to lay more track?
Incentives are the underpinnings for all
the decisions you and others make?

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The Power of Economic Analysis

Incentives
Rewards for engaging in a
particular activity

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The Power of Economic
Analysis (cont'd)
The economic way of thinking is a
framework to analyze solutions to
economic problems.
How much time to study

Choosing which courses to take

Whether troops should be sent abroad

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The Power of Economic
Analysis (cont'd)
The economic way of thinking gives you
the powerthe power to reach
informed conclusions about what is
happening in the world.
Economic analysis helps you make
better decisions, and increases your
understanding when watching or
reading the news on the Web.

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The Power of Economic
Analysis (cont'd)
Economic analysis is a way of thinking
about all decisions.
Your education, career, financing your
home, family
Your involvement in the business world, or
in politics as a voter

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Defining Economics

Economics
The study of how people allocate
their limited resources to satisfy their
unlimited wants
The study of how people make choices

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Defining Economics (cont'd)

Resources
Things used to produce other things to
satisfy peoples wants

Wants
What people would buy if their incomes
were unlimited

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Defining Economics (cont'd)

With limited income (resources),

people must make choices to satisfy
their wants.
We never have enough of everything,
including time, to satisfy our
every desire.

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Defining Economics (cont'd)

Individuals, businesses, and nations

face alternatives, and choices must
be made.
Economics studies how these choices
are made.

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Microeconomics
versus Macroeconomics
Microeconomics
The study of decision making undertaken
by individuals (or households) and by firms
Like looking though a microscope to focus
on the smaller parts of the economy
Decision of a worker to work overtime or not
A familys choice of having a baby
An individual firm advertising

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Microeconomics
versus Macroeconomics (cont'd)
Macroeconomics
The study of the behavior of the economy
as a whole
Deals with economywide phenomena
The national unemployment rate
The rate of growth in the money supply
The national governments budget deficit

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Microeconomics
versus Macroeconomics (cont'd)
Macroeconomics deals with
aggregates, or totalssuch as total
output in an economy.
Modern economic theory blends micro
and macro concepts.

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The Economic Person:
Rational Self-Interest
Economists assume that individuals
act as if motivated by self-interest and
respond predictably to opportunities
for gain.

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The Economic Person:
Rational Self-Interest (cont'd)
It is not from the benevolence of the
butcher, the brewer, or the baker that we
expect our dinner, but from their regard to
their own interest.
Adam Smith, An Inquiry into the Nature
and Causes of the Wealth of Nations, 1776

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The Economic Person:
Rational Self-Interest (cont'd)
Rationality Assumption
The assumption that people do not
intentionally make decisions that would
leave them worse off

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Example: Neuroeconomics
Explores the Rationality Assumption
Economists want to know which parts of the
brain play the greatest role in determining an
individuals choices.
Brain scans reveal considerable coordination
between the limbic system (governing emotions)
and the prefrontal cortex (associated with reason
and calculation).
There is evidence the brain attempts to factor in
reasoned calculations aimed at making a choice
consistent with the best overall outcome.

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The Economic Person:
Rational Self-Interest (cont'd)
Questions
Does the fact that some people make
apparently irrational choices invalidate the
rationality assumption in economics?
Can economic models be applied to
situations in which behavior is at odds with
what we expect from rational people?

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The Economic Person:
Rational Self-Interest (cont'd)
Responding to incentives
Rationality and the use of incentives
Positive incentives
Negative incentives

Making choices
Balancing cost and benefits

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The Economic Person:
Rational Self-Interest (cont'd)
Some examples of incentives
Responding to positive incentives
Schoolchildren getting gold stars, working to
have a better life for yourself

Responding to negative incentives

Penalties,punishments, using credit cards to
avoid check overdrafts

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E-Commerce Example: Playing the Float
with Plastic Instead of Checks

Checks used to take up to several days to clear.

People would rush to make deposits to avoid
overdraft charges.
Technological developments enhanced digital
imaging, and banks have reduced check float.
This has provided incentives for more credit card
purchasesas they allow for deferred payment.
How might high interest rates influence incentives to
use credit cards?

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The Economic Person:
Rational Self-Interest (cont'd)
Defining self-interest
The pursuit of ones goals, does not
always mean increasing ones wealth
Prestige

Friendship

Love

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Example:
The Perceived Value of Gifts
The perceived value of gifts
Often, the recipient of the gift places a
value on it far less than the market value.
Should we substitute gift certificates for
physical gifts?

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Economics as a Science

Models or Theories
Simplified representations of the real
world used as the basis for predictions
or explanations
A map is the quintessential model

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Economics as a Science (cont'd)

Assumptions
The set of circumstances in which a model
is applicable
Every model, or theory, must be based on
a set of assumptions.

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Example: Getting Directions

A map is a simplifying model of reality.

The degree of simplification varies
across maps; some contain more detail
than others.
Economic models attempt to focus on
what is relevant to the problem at hand
and omit what is not.

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Economics as a Science (cont'd)

Ceteris Paribus Assumption

[KAY-ter-us PEAR-uh-bus]
Nothing changes except the factor or
factors being studied.
Other things constant

Other things equal

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Economics as a Science (cont'd)

Economics is an empirical science.

Real-world data is used to evaluate the
usefulness of a model.
Models are useful if they predict economic
phenomena.
Economic models predict how people
react, not how they think.

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Economics as a Science (cont'd)

Behavioral Economics
Approach to the study of
consumer behavior
Emphasizes psychological limitations
and complications which may interfere
with rational decision making

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Economics as a Science (cont'd)

Bounded Rationality
Hypothesis that people are nearly, not
fully, rational
They cannot examine every choice available
to them
Use simple rules of thumb to sort alternatives

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Positive versus
Normative Economics
Positive Economics
Purely descriptive statements or scientific
predictions; If A, then B, a statement
of what is

Normative Economics
Analysis involving value judgments; relates
to whether things are good or bad, a
statement of what ought to be

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Issues and Applications: Do People
Engage in Conspicuous Consumption?

In 1902, economist Thorstein Veblin coined

the phrase conspicuous consumption.
Ori Heffetz of Princeton University looked for
empirical evidence to support Veblins idea.
Evidence showed higher-income people buy
visible items.

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Issues and Applications:
Do People Engage in
Conspicuous Consumption? (cont'd)
Is conspicuous consumption for
real or just a rational response to
higher income?

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Summary Discussion
of Learning Objectives
Microeconomics versus macroeconomics
Economics is the study of how individuals make
choices to satisfy wants.
Microeconomics is the study of decision making
by individual households and individual firms.
Macroeconomics is the study of nationwide
phenomena, such as inflation and
unemployment levels.

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Summary Discussion
of Learning Objectives (cont'd)
Self-interest in economic analysis
Rational self-interest is the assumption
that individuals behave in a reasonable
(rational) way in making choices to further
their interests.

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Summary Discussion
of Learning Objectives (cont'd)
Economics as a science
Economists use models, or theories, that
are simplified representations of the real
world to analyze and make predictions
about the real world.

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Summary Discussion
of Learning Objectives (cont'd)
The difference between positive and
normative economics
Positive economics deals with what is,
whereas normative economics deals with
what ought to be.
Positive statements are of the ifthen
variety, while normative ask what should,
or could be.

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