Chapter 1: The Scope and Method of Economics PDF

This presentation has been prepared to provide accompanying material to undergraduate students, using the book Principles of Economics (11th Edition) by Case, Fair, and Oster. The Scope and Method of Economics CHAPTER OUTLINE Why Study Economics? To Learn a Way of Thinking To Understand Soc...

This presentation has been prepared to provide accompanying material to undergraduate students, using the book Principles of Economics (11th Edition) by Case, Fair, and Oster. The Scope and Method of Economics CHAPTER OUTLINE Why Study Economics? To Learn a Way of Thinking To Understand Society To Be an Informed Citizen The Scope of Economics Microeconomics and Macroeconomics The Diverse Fields of Economics The Method of Economics Theories and Models Economic Policy Appendix: How to Read and Understand Graphs The study of economics should begin with a sense of wonder. Pause for a moment and consider a typical day in your life. It might start with a bagel made in a local bakery with flour produced in İstanbul from wheat grown in Konya. After class, you drive with a friend on an interstate highway that is part of a system that took 20 years and billions of dollars to build. You stop for gasoline refined in Kocaeli from Saudi Arabian crude oil. You use or consume tens of thousands of things in a day. Someone organized men and women and materials to produce and distribute these things. Thousands of decisions went into their completion, and somehow they got to you. economics The study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. The key word in this definition is choose. Economics is a behavioral, or social, science. In large measure, it is the study of how people make choices. The choices that people make, when added up, translate into societal choices. Why Study Economics? There are three main reasons to study economics: 1) To learn a way of thinking, 2) To understand society, 3) To be an informed citizen. Why Study Economics? To Learn a Way of Thinking Probably the most important reason for studying economics is to learn a way of thinking. Economics has three fundamental concepts that, once absorbed, can change the way you look at everyday choices: opportunity cost, marginalism, and the working of efficient markets. Three fundamental concepts: ▪ Opportunity cost ▪ Marginalism ▪ Efficient markets Opportunity Cost Nearly all decisions involve trade-offs. A key concept that recurs in analyzing the decision-making process is the notion of opportunity cost. The full “cost” of making a specific choice includes what we give up by not making the best alternative choice. opportunity cost The best alternative that we forgo, or give up, when we make a choice or a decision. When asked how much a movie costs, most people cite the ticket price. For an economist, this is only part of the answer: to see a movie takes not only a ticket but also time. The opportunity cost of going to a movie is the value of the other things you could have done with the same money and time. Opportunity costs arise because resources are scarce. Scarce simply means limited. Marginalism marginalism The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. For an airplane that is about to take off with empty seats, the marginal cost of an extra passenger is essentially zero; the total cost of the trip is roughly unchanged by the addition of an extra passenger. Thus, setting aside a few seats to be sold at big discounts. Efficient Markets—No Free Lunch Suppose you are ready to check out at a busy grocery store on the day before a storm and seven checkout registers are open with several people in each line. Which line should you choose? Clearly, you should go to the shortest line! But if everyone thinks this way—as is likely—all the lines will be equally long as people move around. efficient market A market in which profit opportunities are eliminated almost instantaneously. The study of economics teaches us a way of thinking and helps us make decisions. To Understand Society Past and present economic decisions have an enormous influence on the character of life in a society. The current state of the physical environment, the level of material well-being, and the nature and number of jobs are all products of the economic system. Industrial Revolution The period in England during the late eighteenth and early nineteenth centuries in which new manufacturing technologies and improved transportation gave rise to the modern factory system and a massive movement of the population from the countryside to the cities. The study of economics is an essential part of the study of society. To Be an Informed Citizen To be an informed citizen requires a basic understanding of economics. A knowledge of economics is essential to being an informed citizen. Between 2008 and 2013, much of the world struggled with a major recession and slow recovery, leaving millions of people around the world out of work. Understanding what happens in a recession and what the government can and cannot do to help in a recovery is an essential part of being an informed citizen. Economics is also essential in understanding a range of other everyday government decisions at the local and federal levels. Why do governments pay for public schools and roads, but not cell phones? EC ON OMIC S IN PRACTICE iPod/iPhone and the World A sticker that says “Made in China” can often be misleading. Indeed, for the iPod, which is composed of many small parts, it is almost impossible to accurately tell exactly where each piece was produced without pulling it apart. From an economics point of view, one often has to dig a little deeper to see what is really going on. THINKING PRACTICALLY 1. What do you think accounts for where components of the iPod/iPhone are made? The Scope of Economics Microeconomics and Macroeconomics microeconomics The branch of economics that examines the functioning of individual industries and the behavior of individual decision-making units—that is, firms and households. macroeconomics The branch of economics that examines the economic behavior of aggregates—income, employment, output, and so on—on a national scale. Microeconomics looks at the individual unit—the household, the firm, the industry. It sees and examines the “trees.” Macroeconomics looks at the whole, the aggregate. It sees and analyzes the “forest.” TABLE 1. Examples of Microeconomic and Macroeconomic Concerns Division of Economics Production Prices Income Employment Microeconomics Production/output Prices of individual Distribution of Employment by in individual goods and services income and individual industries and wealth businesses and businesses industries How much steel Price of medical care Wages in the Jobs in the steel How much office Price of gasoline auto industry industry space Food prices Minimum wage Number of How many cars Apartment rents Executive employees in a firm salaries Number of Poverty accountants Macroeconomics National Aggregate price level National income Employment and production/output unemployment in the economy Total industrial Consumer prices Total wages and Total number of jobs output Producer prices salaries Unemployment rate Gross domestic Rate of inflation Total corporate product profits Growth of output The Diverse Fields of Economics TABLE 2 The Fields of Economics Behavioral economics uses psychological theories relating to emotions and social context to help understand economic decision making and policy. Much of the work in behavioral economics focuses on the biases that individuals have that affect the decisions they make. Comparative economic examines the ways alternative economic systems function. What are the systems advantages and disadvantages of different systems? Econometrics applies statistical techniques and data to economic problems in an effort to test hypotheses and theories. Most schools require economics majors to take at least one course in statistics or econometrics. Economic development focuses on the problems of low-income countries. What can be done to promote development in these nations? Important concerns of development for economists include population growth and control, provision for basic needs, and strategies for international trade. Economic history traces the development of the modern economy. What economic and political events and scientific advances caused the Industrial Revolution? What explains the tremendous growth and progress of post-World War II Japan? What caused the Great Depression of the 1930s? Continued... The Diverse Fields of Economics TABLE 2 The Fields of Economics (continued) Environmental studies the potential failure of the market system to account fully for the economics impacts of production and consumption on the environment and on natural resource depletion. Have alternative public policies and new economic institutions been effective in correcting these potential failures? Finance examines the ways in which households and firms actually pay for, or finance, their purchases. It involves the study of capital markets (including the stock and bond markets), futures and options, capital budgeting, and asset valuation. Health economics analyzes the health care system and its players: government, insurers, health care providers, and patients. It provides insight into the demand for medical care, health insurance markets, cost-controlling insurance plans (HMOs, PPOs, IPAs), government health care programs (Medicare and Medicaid), variations in medical practice, medical malpractice, competition versus regulation, and national health care reform. The history of economic which is grounded in philosophy, studies the development of economic ideas thought, and theories over time, from Adam Smith in the eighteenth century to the works of economists such as Thomas Malthus, Karl Marx, and John Maynard Keynes. Because economic theory is constantly developing and changing, studying the history of ideas helps give meaning to modern theory and puts it in perspective. Continued... The Diverse Fields of Economics TABLE 2 The Fields of Economics (continued) Industrial organization looks carefully at the structure and performance of industries and firms within an economy. How do businesses compete? Who gains and who loses? International economics studies trade flows among countries and international financial institutions. What are the advantages and disadvantages for a country that allows its citizens to buy and sell freely in world markets? Why is the dollar strong or weak? Labor economics deals with the factors that determine wage rates, employment, and unemployment. How do people decide whether to work, how much to work, and at what kind of job? How have the roles of unions and management changed in recent years? Law and economics analyzes the economic function of legal rules and institutions. How does the law change the behavior of individuals and businesses? Do different liability rules make accidents and injuries more or less likely? What are the economic costs of crime? Public economics examines the role of government in the economy. What are the economic functions of government, and what should they be? How should the government finance the services that it provides? What kinds of government programs should confront the problems of poverty, unemployment, and pollution? What problems does government involvement create? Urban and regional studies the spatial arrangement of economic activity. Why do we have cities? economics Why are manufacturing firms locating farther and farther from the center of urban areas? The Method of Economics positive economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It describes what exists and how it works. normative economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics. Theories and Models In many disciplines, including physics, chemistry, meteorology, political science, and economics, theorists build formal models of behavior. A model is a formal statement of a theory. It is usually a mathematical statement of a presumed relationship between two or more variables. variable A measure that can change from time to time or from observation to observation. Because all models simplify reality by stripping part of it away, they are abstractions. Critics of economics often point to abstraction as a weakness. Most economists, however, see abstraction as a real strength. All Else Equal: Ceteris Paribus ceteris paribus, or all else equal A device used to analyze the relationship between two variables while the values of other variables are held unchanged. Using the device of ceteris paribus is one part of the process of abstraction. In formulating economic theory, the concept helps us simplify reality to focus on the relationships that interest us. Expressing Models in Words, Graphs, and Equations We use both graphs and equations to capture the quantitative side of our economic observations and predictions. Cautions and Pitfalls What Is Really Causal? In much of economics, we are interested in cause and effect. But cause and effect are often difficult to figure out. Recently, many people in the United States have begun to worry about consumption of soda and obesity. Some areas have begun taxing soda trying to raise the price so that people will drink less of it. post hoc, ergo propter hoc fallacy Literally, “after this (in time), therefore because of this.” A common error made in thinking about causation: If Event A happens before Event B, it is not necessarily true that A caused B. The Fallacy of Composition fallacy of composition The erroneous belief that what is true for a part is necessarily true for the whole. Testing Theories and Models: Empirical Economics empirical economics The collection and use of data to test economic theories. Economic Policy Economic theory helps us understand how the world works, but the formulation of economic policy requires a second step. We must have objectives. What do we want to change? Why? What is good and what is bad about the way the system is operating? Can we make it better? Such questions force us to be specific about the grounds for judging one outcome superior to another. What does it mean to be better? Four criteria are frequently applied in judging economic outcomes: 1. Efficiency 2. Equity 3. Growth 4. Stability Efficiency In economics, efficiency means allocative efficiency. An efficient economy is one that produces what people want at the least possible cost. If the system allocates resources to the production of goods and services that nobody wants, it is inefficient. If all members of a particular society were vegetarians and somehow half of all that society’s resources were used to produce meat, the result would be inefficient. If you and I each want something that the other has and we agree to exchange, we are both better off and no one loses. Equity equity Fairness. To many, fairness implies a more equal distribution of income and wealth. Growth economic growth An increase in the total output of an economy. If output grows faster than the population, output per person rises and standards of living increase. Stability stability A condition in which national output is growing steadily, with low inflation and full employment of resources. APPENDIX How to Read and Understand Graphs A graph is a two-dimensional representation of a set of numbers, or data. Time Series Graphs A time series graph shows how a single measure or variable changes over time. TABLE 1A Total Disposable Personal  FIGURE 1A Total Disposable Personal Income in the Income in the United States, 1975–2012 United States: 1975–2012 (in billions of dollars) (in billions of dollars) Total Total Disposable Disposable Personal Personal Year Income Year Income 1975 1,187.3 1994 5,184.3 1976 1,302.3 1995 5,457.0 1977 1,435.0 1996 5,759.6 1978 1,607.3 1997 6,074.6 1979 1,790.8 1998 6,498.9 1980 2,002.7 1999 6,803.3 1981 2,237.1 2000 7,327.2 1982 2,412.7 2001 7,648.5 1983 2,599.8 2002 8,009.7 1984 2,891.5 2003 8,377.8 1985 3,079.3 2004 8,889.4 1986 3,258.8 2005 9,277.3 1987 3,435.3 2006 9,915.7 1988 3,726.3 2007 10,423.6 1989 3,991.4 2008 11,024.5 1990 4,254.0 2009 10,772.4 1991 4,444.9 2010 11,127.1 1992 4,736.7 2011 11,549.3 1993 4,921.6 2012 11,930.6 Graphing Two Variables X-axis The horizontal line against which a variable is plotted. Y-axis The vertical line against which a variable is plotted. origin The point at which the horizontal and vertical axes intersect. Y-intercept The point at which a graph intersects the Y-axis. X-intercept The point at which a graph intersects the X-axis.  Plotting Income and Consumption Data for Households TABLE 2A Consumption Expenditures and Income, 2008 Average Average Income Consumption Before Taxes Expenditures Bottom fifth $ 10,263 $ 22,304 2nd fifth 27,442 31,751 3rd fifth 47,196 42,659 4th fifth 74,090 58,632 Top fifth 158,652 97,003  FIGURE 2A Household Consumption and Income A graph is a simple two-dimensional geometric representation of data. This graph displays the data from Table 2A. Along the horizontal scale (X-axis), we measure household income. Along the vertical scale (Y-axis), we measure household consumption. Note: At point A, consumption equals $22,304 and income equals $10,263. At point B, consumption equals $31,751 and income equals $27,442. positive relationship A relationship between two variables, X and Y, in which a decrease in X is associated with a decrease in Y, and an increase in X is associated with an increase in Y. negative relationship A relationship between two variables, X and Y, in which a decrease in X is associated with an increase in Y and an increase in X is associated with a decrease in Y. Slope slope A measurement that indicates whether the relationship between variables is positive or negative and how much of a response there is in Y (the variable on the vertical axis) when X (the variable on the horizontal axis) changes. Y Y2 − Y1 = X X 2 − X 1  FIGURE 3A Changing Slopes Along Curves Some Precautions TABLE 3A Aggregate National Income and Consumption for the United States, 1930–2012 (in billions of dollars) Aggregate Aggregate National Income Consumption 1930 82.9 70.1 1940 90.9 71.3 1950 263.9 192.2 1960 473.9 331.8 1970 929.5 648.3 1980 2433.0 1,755.8 1990 5059.8 3,835.5 2000 8938.9 6,830.4 2005 11,273.8 8,803.5 2006 12,031.2 9,301.0 2007 12,396.4 9,772.3 2008 12,609.1 10,035.5 2009 12,132.6 9,845.9 2010 12,811.4 10,215.7 2011 13,358.9 10,729.0 2012 13,720.9 11,119.5  FIGURE 4A National Income and Consumption It is important to think carefully about what is represented by points in the space defined by the axes of a graph. In this graph, we have graphed income with consumption, as in Figure 1A.2, but here each observation point is national income and aggregate consumption in different years, measured in billions of dollars.