1-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Chapter 1

The nature and method of economics

1-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Learning objectives• Is the study of economics of consequence

or importance?• What is the methodology of economics?

In other words, how should we study economics? What are the proper methods by which its study is best achieved?

• What specific problems, limitations and pitfalls

can we encounter in studying economics?• What characterises or identifies an ‘economic

perspective’?

1-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The roles of economics• Economics is concerned with the efficient

use of limited productive resources for the purpose of attaining the maximum satisfaction of our material wants

1-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The roles of economics (cont.)• Why study economics? John Maynard

Keynes offered the following response:

‘The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.’

Keynes, 1936

1-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The age of the economists• Adam Smith• David Ricardo• John Stuart Mill• Karl Marx• Jon Maynard Keynes• Plus many modern contributors

1-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The roles of economics (cont.)• Economics for citizenship

– To create well-informed members of society

• Economics in business– To provide business with strategic information

and interpretations

• Personal applications– To assist individuals, as workers and income

receivers, to gain and retain economic security

1-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Methodology of economics• What do economists do? What are their goals?

What methods do they use?– Economists derive economic principles that are

useful in formulating policies designed to solve economic problems

• The methods used by the economists are:1. Facts — descriptive or empirical economics

concerned with gathering facts relevant to an economic problem

2. Principles or theories — economists generalise about economic behaviour formulating economic theory

3. Policies — formulating policies for correcting the problem under scrutiny called applied economics

1-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Induction and deduction• Induction

– A method of reasoning that proceeds from facts to generalisations

• Deduction– Reasoning from assumptions to conclusions

by testing a hypothesis

1-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Descriptive economics• Complex in economics unlike physical sciences

– Economics is a social science involving the complexities of individuals and institutions

– Facts are difficult to gather and interpret– Economists must use discretion in collecting data, and

must distinguish economic from non-economic facts

1-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Economic theory• Facts must be systematically arranged,

interpreted and generalised to derive appropriate economic theory

• Theories or principles are the end result of economic analysis. These are meaningful statements drawn from facts

1-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Terminology of economic theory• Economists use the terms ‘laws',' principles’

‘theories’ and ‘models’ to represent generalisations, or statements of regularity, concerning the economic behaviour of individuals and institutions

• A model is a simplified picture of reality, an abstract generalisation of how the relevant data actually behave

1-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Generalisations in economics• Economic principles are generalisations, and

subject to exceptions and to quantitatively imprecise statements

• Economic principles are often stated in terms of averages or statistical probabilities

• Generalisations, properly handled and interpreted can be both meaningful and useful

1-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Economic theory• The ‘other things being equal’ assumption

– The process of analysis, that all other variables, other than the one being considered are constant, often referred to as ceteris paribus

• Abstractions in economics– Economic theories do not encompass the full

complexity of reality– Economic model enables us to understand reality

because it avoids the details of reality

1-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Microeconomics and macroeconomics

• Macroeconomics deals with the economy as a whole, or with the basic subdivisions or aggregates that make up the economy

– An aggregate is a collection of specific economic units that are treated as if they were one unit

• Microeconomics is concerned with specific economic units and a detailed consideration of the behaviour of these individuals units

1-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Policy economics: positive and normative• Positive economics deals with facts (and theories about

these facts) and avoids value judgments. Attempts to set out scientific statements about economic behaviour

• Normative economics are based upon someone’s value judgments about what the economy should be like or what particular policy action should be recommended, based on a given economic generalisation or relationship. It embodies subjective feeling about ‘what ought to be’

– Normative economic statements come into play at the level of policy economics

1-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Economic goals

1. Economic growth

2. Full employment

3. Economic efficiency

4. Price-level stability

5. Economic freedom

6. An equitable distribution of income

7. Economic security

8. External balance

1-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Economic goals (cont.)• Interpretation

– The basic economic goals inevitably entails problems of interpretations — what are ‘sizeable’ ‘high degree’ and ‘equitable’?

• Complementary goals– Some of the goals are complementary

• Conflicting goals– Many goals are conflicting or mutually exclusive,

and involve ‘trade-offs’

• Priorities– When goals conflict, society has to prioritise

1-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Formulating economic policyThree basic steps in policy formulation:• Stating goals

– Define the goals clearly

• Policy options– State and recognise the possible effects of alternative

policies designed to achieve the goal

• Evaluation– Review the policies and evaluate their effectiveness

1-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Pitfalls to objective thinking• Bias• Loaded terminology• Definitions• Fallacy of composition

– What is true for the individual or part is not necessarily true for the group or whole

• Cause and effect– Post-hoc fallacy– Correlation versus causation

• Economic quackery

1-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The economic perspective• Scarcity and choice

– Resources are limited and this necessitates choices

• Rational behaviour– Behaviour that involves decisions and actions

in order to achieve the greatest satisfaction or maximum fulfilment of goals

– People will make different choices, because their circumstances, preferences and available information differ

1-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The economic perspective (cont.)• Marginalism: benefits and costs

– Decision that compare marginal benefits and marginal costs

– Incremental benefits available from any changes are compared to the incremental costs of making the change

1-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Graphs and their meaning

Appendix to Chapter 1

1-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Constructing a graph• Two-dimensional graph

– Horizontal axis representing independent variable– Vertical axis representing dependent variable– Intersection (0) is origin

1-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Direct and indirect relationships

• Graphing relationships between variables– Direct relationship:

Where the values of two related variable change in the same direction, e.g. consumption and income

– Inverse relationship: Where the values of two related variables move in opposite directions, e.g. ticket prices and attendance

1-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Direct relationship

0

$500

$400

$300

$200

$100

$100 $200 $300 $400

Co

nsu

mp

tio

n (

C)

Income (Y)

ConsumptionC = 50 + 0.5Y

ab

c

de

As Y increases, C increases

1-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Inverse relationship

0

$25

$20

$15

$10

$5

4 8 12 16 20

Tic

ket

pri

ce (

P)

Attendance in thousands (Q)

Ticket demand

a

b

c

d

f

As P increases, Q decreases

e

P = 25 – 1.25Q

1-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Dependent and independent variables• Dependent variable:

– The variable which changes as a consequence of a change in some other (independent) variable

• Independent variable: – The variable which causes a change in some other

(dependent) variable

1-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Other variables held constant• When economists plot the relationship between

any two variables, they assume that ‘other things being equal’; that is, all other factors that might affect consumption are presumed to be constant or unchanged

1-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Slope of a straight line• The ratio of the vertical change (the rise

or fall) to the corresponding horizontal change involved in moving between two points

1-30Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

vertical change = +50

horizontal change = +100

Positive slope

o

$500

$400

$300

$200

$100

$100 $200 $300 $400

Co

nsu

mp

tio

n (

C)

Income (Y)

ConsumptionC = 50 + 0.5Y

ab

c

de

5.0100

50

change horizontal

change verticalSlope

1-31Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

– 5

+ 4

Negative slope

0

$25

$20

$15

$10

$5

4 8 12 16 20

Tic

ket

pri

ce (

P)

Attendance in thousands (Q)

Ticket demand

P = 25 – 1.25Q

a

b

c

d

f

25.14

5

change horizontal

change verticalSlope

e

1-32Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Slope of a lineThree addenda• Measurement units

– The slope of a line is affected by the choice of units for either variable

• Marginal analysis– The slope of a line measures marginal changes

• Infinite and zero slopes– Variables that are unrelated or independent of one

another will be represented by a line parallel to the vertical or horizontal axis, and will have a slope of infinity or zero, respectively

1-33Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Slope of a line (cont.)• Intercept

– The vertical intercept is the point at which the line meets the vertical axis

• Equation form– Linear equation

y = a + bx

Where: y = the dependent variable

a = the vertical intercept

b = the slope of the line

x = the independent variable

1-34Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

a

a

Slope of a non-linear relationship or curve

PA

A

Tangent

X

Y

1-35Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Slope of a curve (cont.)

X

Y40

30

20

10

010 20 30 40

b

b

P

1-36Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Next chapter:

The economising problem