LECTURE

The Scope and Method of C:\WINDOWS\hinhem.scrFC:\WINDOWS\hinhem Economics

Economy. . .
. . . The word economy comes from a Greek word for one who manages a household.

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The Study of Economics

Economics is the study of how individuals and societies choose to use the scarce resources. Economics is the study of how society manages its scarce resources. Economics is the science of how individuals and societies deal with the fact that wants are greater than the limited resources available to satisfy those wants.
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Economic Definitions
Society and Scarce Resources:
Resources are things used in the production of goods

and services.
The management of societys resources is important

because resources are scarce.

Scarcity. . . means that society has limited resources

and therefore cannot produce all the goods and services people wish to have.

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Resources
Economists have traditionally grouped resources into four broad categories
land labor capital (also called investment goods), and technology

Economists would add a fifth category, entrepreneurial talent.

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Resources
Land includes the surface area of the world and everything in natureminerals, chemicals, plantsthat is useful in the production process. Labor includes any way in which human energy, physical or mental, can be usefully expended. Capital (investment goods) includes any output of a production process that is designed to be used later in other production processes. Plants and equipmentthings produced to produce other thingsare examples of these manufactured means of production. Technology is the knowledge of how resources can be combined in productive ways. An entrepreneur is an enterprising person who discovers potentially profitable opportunities and organizes, directs, and manages productive ventures.
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Why Study Economics?

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

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Thinking Like an Economist

Every field of study has its own terminology
Mathematics
integrals axioms vector spaces

Psychology
ego id cognitive dissonance

Law
promissory estoppel torts venues

Economics
supply opportunity cost elasticity consumer surplus

demand comparative advantage deadweight loss

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Thinking Like an Economist

Economics trains you to. . . .
Think in terms of alternatives.
Evaluate the cost of individual and social choices. Examine and understand how certain events and

issues are related.

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Thinking Like an Economist

The economic way of thinking . . .
Involves thinking analytically and objectively.
Makes use of the scientific method.

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The Scientific Method: Observation, Theory, and More Observation

Uses abstract models to help explain how a complex, real world operates. Develops theories, collects, and analyzes data to evaluate the theories.

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Theories and Models

A theory is a general statement of cause and effect, action and reaction. Theories involve models, and models involve variables. A model is a formal statement of a theory. Models are descriptions of the relationship between two or more variables. Ockhams razor is the principle that irrelevant detail should be cut away. Models are simplifications, not complications, of reality.
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Theories and Models

A variable is a measure that can change from observation to observation. Using the ceteris paribus, or all else equal, assumption, economists study the relationship between two variables while the values of other variables are held unchanged. The ceteris paribus device is part of the process of abstraction used to focus only on key relationships.
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Theories and Models

In formulating theories and models we must avoid two pitfalls:
The Post Hoc Fallacy: It is erroneous to believe that

if event A happened before event B, then A caused B.

The Fallacy of Composition: It is erroneous to

believe that what is true for a part is also true for the whole. Theories that seem to work well when applied to individuals often break down when they are applied to the whole.

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The Role of Assumptions

Economists make assumptions in order to make the world easier to understand. The art in scientific thinking is deciding which assumptions to make. Economists use different assumptions to answer different questions.

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Economic Models
Economists use models to simplify reality in order to improve our understanding of the world One of the most basic economic model:
The Circular Flow Diagram

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Our First Model: The Circular-Flow Diagram

The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

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Figure 1 The Circular Flow

MARKETS FOR GOODS AND SERVICES Firms sell Goods Households buy and services sold Revenue

Spending Goods and services bought

FIRMS Produce and sell goods and services Hire and use factors of production

HOUSEHOLDS Buy and consume goods and services Own and sell factors of production

Factors of production Wages, rent, and profit

MARKETS FOR FACTORS OF PRODUCTION Households sell Firms buy

Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars

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Our First Model: The Circular-Flow Diagram

Firms
Produce and sell goods and services
Hire and use factors of production

Households
Buy and consume goods and services Own and sell factors of production

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Our First Model: The Circular-Flow Diagram

Markets for Goods and Services
Firms sell
Households buy

Markets for Factors of Production

Households sell Firms buy

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Our First Model: The Circular-Flow Diagram

Factors of Production
Inputs used to produce goods and services
Land, labor, and capital

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Market
A market is the process by which buyers and sellers determine what they are willing to buy and sell and on what terms. In other words, it is the process by which buyers and sellers decide the prices and quantities of goods that are to be bought and sold.

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Thinking Like an Economist

Economics trains you to. . . .
Think in terms of alternatives.
Evaluate the cost of individual and social choices. Examine and understand how certain events and

issues are related.

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Thinking Like an Economist

A household and an economy face many decisions:
Who will work? What goods and how many of them should be

produced?
What resources should be used in production? At what price should the goods be sold?

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Thinking Like an Economist

How people make decisions.
People face tradeoffs.
The cost of something is what you give up to get it.

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People Face Tradeoffs

There is no such thing as a free lunch!

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People Face Tradeoffs

To get one thing, we usually have to give up another thing.
Guns v. butter Food v. clothing Leisure time v. work Efficiency v. equity

Making decisions requires trading off one goal against another.

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People Face Tradeoffs

Efficiency v. Equity
Efficiency means society gets the most that it can

from its scarce resources.

Equity means the benefits of those resources are

distributed fairly among the members of society.

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The Cost of Something Is What You Give Up to Get It

Decisions require comparing costs and benefits of alternatives.
Whether to study or watch movie? Whether to go to class or sleep in?

The opportunity cost of an item is what you give up to obtain that item.

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Opportunity Cost
Opportunity cost is the best alternative that we forgo, or give up, when we make a choice or a decision. Opportunity costs arise because time and resources are scarce. Nearly all decisions involve trade-offs.

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Thinking Like an Economist

Economics trains you to. . . .
Think in terms of alternatives.
Evaluate the cost of individual and social choices. Examine and understand how certain events and

issues are related.

The economic way of thinking . . .

Involves thinking analytically and objectively.
Makes use of the scientific method.
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The Scope of Economics

Microeconomics is the branch of economics that examines the functioning of individual industries and the behavior of individual decision-making unitsthat is, business firms and households. Microeconomics focuses on the individual parts of the economy.

How households and firms make decisions and how they interact in specific markets
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The Scope of Economics

Macroeconomics is the branch of economics that examines the economic behavior of aggregates. Macroeconomics looks at the economy as a whole on a national scale Economy-wide phenomena: inflation, output, employment-unemployment, economic growth and so on

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The Diverse Fields of Economics

Examples of microeconomic and macroeconomic concerns
Production Microeconomics Production/Output in Individual Industries and Businesses How much steel How many offices How many cars Macroeconomics National Production/Output Total Industrial Output Gross Domestic Product Growth of Output Prices Price of Individual Goods and Services Price of medical care Price of gasoline Food prices Apartment rents Aggregate Price Level Consumer prices Producer Prices Rate of Inflation Income Distribution of Income and Wealth Wages in the auto industry Minimum wages Executive salaries Poverty National Income Total wages and salaries Total corporate profits Employment Employment by Individual Businesses & Industries Jobs in the steel industry Number of employees in a firm Employment and Unemployment in the Economy Total number of jobs Unemployment rate

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Typical Macroeconomic Questions

What determines the general price level? The rate of inflation? What determines national income and production levels?

What determines national employment and unemployment levels?

What effects do government monetary and budgetary policies have on the general price, income, production, employment, and unemployment levels?
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Typical Microeconomic Questions

What determines the price of particular goods and services? What determines the output of particular firms and industries? What determines the wages workers receive? The interest rates lenders receive? The profits businesses receive? How do government policiessuch as minimum wage laws, price controls, tariffs, and excise taxesaffect the price and output levels of individual markets? Why do incentives matter inside firms and how can economic theory be used to properly structure a firms incentives to increase worker productivity and firm profitability?

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Linkage
The Linkage Between Micro and Macroeconomics

Microeconomics is the foundation of macroeconomic analysis

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THE ECONOMIST AS POLICY ADVISOR

When economists are trying to explain the world, they are scientists. When economists are trying to change the world, they are policy advisor.

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The Method of Economics

Normative economics, also called policy economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action.
Positive economics studies economic behavior without making judgments. It describes what exists and how it works.

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POSITIVE VERSUS NORMATIVE ANALYSIS

Positive statements are statements that attempt to

describe the world as it is.

Called descriptive analysis

Normative statements are statements about how

the world should be.

Called prescriptive analysis

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POSITIVE VERSUS NORMATIVE ANALYSIS

Positive or Normative Statements?
An increase in the minimum wage will cause a

decrease in employment among the least-skilled. POSITIVE

Higher federal budget deficits will cause interest rates

to increase.

POSITIVE

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POSITIVE VERSUS NORMATIVE ANALYSIS

Positive or Normative Statements?
The income gains from a higher minimum wage are

worth more than any slight reductions in employment. NORMATIVE

State governments should be allowed to collect from

tobacco companies the costs of treating smokingrelated illnesses among the poor. NORMATIVE
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The Method of Economics

Positive economics includes:
Descriptive economics, which involves the

compilation of data that describe phenomena and facts.

Economic theory that involves building models of

behavior. A theory is a statement or set of related statements about cause and effect, action and reaction.

Empirical economics refers to the collection and use of data to test economic theories.
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Economic Methodology
Policy Economics

Theoretical Economics Theories

Facts
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Economic Policy

STATE THE GOAL

POLICY OPTIONS

IMPLEMENT & EVALUATE

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Economic Goals: Trade Offs

Economic Growth Full Employment Economic Efficiency Price-Level Stability Economic Freedom Equitable Distribution Economic Security Balance of Trade

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Summary
Economists try to address their subjects with a scientists objectivity.
They make appropriate assumptions and build

simplified models in order to understand the world around them.

One simple economic model is circular-flow diagram

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Summary
Economics is divided into two sub-fields:
Microeconomists study decision making by

households and firms in the marketplace.

Macroeconomists study the forces and trends that

affect the economy as a whole

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Summary
A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisors than scientists.

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Summary
Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values.

At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.

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