Lecture 1

What is Economics?

What is Economics?

Readings: Chapter 1

What is Economics? It is a social science concerned with understanding

the forces that shape social values and social behaviour.

By understanding these forces, economists hope to better understand why social values and social behaviours change, and the implications of such changes.

What is Economics?

What is Changing? Over the last 200 years, science, economic growth,

and the forces of globalization have dramatically transformed prices, laws, social norms and other social values. The international market place has created local markets and

has created a common set of world prices Global private corporations emerged to organize

extraordinarily complex production processes that straddle the earth.

Representative democracy was invented and is spreading fast.

Government expenditures on public services have grown faster than most economies.

These changing social values are profoundly changing the social behaviour of human beings.

What is Economics?

How can we investigate human social values and social behaviour?

Theory Empirical evidence.

Biologists already do this with bees and other species. http://www.youtube.com/watch?v=VsCmSWoF8PY&feature=related

Both Bees and humans are social animals. Why cannot human social values and social behaviours best understood as biological systems?

http://www.earthcam.com/usa/newyork/timessquare/ http://www.youtube.com/watch?v=MODmEMm1Ql8&feature=related A crucially important difference is that bees are

governed by a biological instinct to perform a community function. Instead of instinct, humans are motivated by individual values (wants) as well as social values.

What is Economics?

Is it easy to discover the forces shaping social values and social behaviour?

Two common mistakes are often encountered in trying to unlock truth: Post-Hoc Fallacy (post hoc ergo propter hoc) Fallacy of Composition (What is true of part of the whole

must must be true of the whole). An economic example is the famous Paradox of Thrift:

A. If a household saves more money now, instead of spending, it will have more money to spend in the future.

B. Therefore, if all households save more money now, instead of spending, they will all have more money to spend in the future.

What is Economics?

How can these fallacies be avoided? To avoid these mistakes, the physical

sciences employ controlled experiments. In economics, such experiments are usually

too costly, too difficult, or immoral to perform.

What is Economics?

To avoid errors in interpreting relationships, economists rely heavily on developing economic models:

Theoretical models enable simple thought experiments to replace controlled experiments.

Statistical models enable examination of the historical record to isolate individual factors influencing social outcomes.

The objective is to be able to identify how changing one thing (independent variable) influences another (dependent variable) while holding all other things constant (ceteris paribus)

What is Economics?

Economic models are abstractions for examining the social phenomenon of interest with the extraneous detail cut-away to reveal underlying relationships that would otherwise be hidden.

Abstractions should be as simple as possible (Ockham’s razor), but there is always a danger of oversimplification.

If these models are any good they will help us: better understand the workings of the social world around

us (Positive Economics) design changes to our social world in order to make it a

better place (Normative Economics).

What is Economics?

Over time, two sorts of economic models have developed to examine the forces behind the formation of social values and social behaviour.

Microeconomics (Fall Term) is primarily concerned with how modern human social systems are organized. In particular economists are very interested in how markets work, the motivations and decisions of human institutions (families, business, government), and how markets and institutions interact with one another.

Macroeconomics (Winter Term) is primarily concerned with the economy as a whole , and how the economy moves through time (dynamics such as inflation, economic growth, etc.).

What is Economics?

Where do all economic models begin? Economics is distinct from the other social sciences in

that it concerns itself with understanding the social forces that stem from the problem of scarcity?

For economists, scarcity is the human existential problem, and social values and social behaviour are a response to this problem.

What is Economics?

What is the cause of scarcity? There are two causes:

1. Our finite world has limited resources.2. Human nature tends towards unlimited wants.

Without unlimited human wants scarcity would not be a problem.

Can scarcity be defeated? No. Even the richest human beings

confront scarcity every day. Attempts to moderate wants through moral

education have largely failed.

What is Economics?

How do human beings deal with scarcity? Humans attempt to as best they can by

1. Rational Choice2. Investment3. Social Cooperation.

Economists believe that by understanding rational choice, investment, and cooperation, we can better understand the social forces governing society.

What is Economics?

How do people make rational decisions? People try their best to choose a plan of action

which provides them with the best outcome possible.

Very often the best plan of action is the one which provides highest net benefit where:

Net Benefit = Benefit - Cost

What is Economics?

Example: How many hours should you study in a 24 hour day?

Identifying your best study strategy is a difficult problem because to solve it directly we need to: Identify a function that translates all possible

strategies into a benefit payout. Identify a function that translates all possible

strategies into an unavoidable cost. Subtract the cost function from the benefit function to

derive the net benefit function. Use calculus to find where the net benefit function is

maximized.

What is Economics?

Study Hours

Satisfaction

Total Cost

Total BenefitNet Benefit

What is Economics?

What are the benefits and costs in this problem? The benefit of study includes satisfaction from

learning and the satisfaction from the opportunities that learning may afford.

The costs of study are all opportunity costs .

What is Economics?

What is an opportunity cost? When making choices all people face trade-offs.

Doing one thing means not doing something else. The opportunity cost of something is what you give

up to get it. The opportunity cost of study is the satisfaction

that could have been enjoyed in the next best alternative use of that time.

With a little thought you can see that all economic costs are in fact opportunity costs.

What is Economics?

Do people choose strategies in this way? No! Calculating a net benefit function is difficult. Even if they could it is doubtful that many would use calculus

to find the maximum of this function.

Can experts provide advice on choosing an optimal strategy for studying?

No! Notice that the benefits and opportunity costs are satisfaction – a purely subjective value.

Because the value of costs and benefits are subjective, the optimal strategy can be expected to vary from person to person.

What is Economics?

Does this mean people are too stupid to be capable of rational choice?

No! Economists have identified a secret algorithm that allows even the dullest to choose rationally.

The secret algorithm is known to economists as the principle of marginalism

What is Economics?

To see how marginalism works, consider our earlier problem of how many hours to study. Instead of asking what the optimal strategy is, ask the simpler question of whether the benefits from the additional hour (marginal benefit) from study outweigh the costs of the additional hour (marginal cost) from study.

Algorithm: Principle of Marginalism If the marginal benefit exceeds the marginal cost from an

additional hour of studying, then it is rational to increase your activity (studying).

If the marginal cost exceeds the marginal benefit from an additional hour of studying, then it is rational to reduce your activity (studying).

Continue adjusting your activity until marginal benefit equals marginal cost.

What is Economics?

Study Hours

Satisfaction

Total Cost

Total BenefitNet Benefit

H0 H1H*

What is Economics?

How do humans invest when confronted by scarcity? Investment is a two-step process in which:

i) current consumption is sacrificed (saved)

ii) savings are used to construct tools (invest) that expands human power over the world

Examples: Sacrifice wheat consumption to increase seed Sacrifice profits to build a new machine Sacrifice income to acquire knowledge

What is Economics?

How much should a person invest?

Investment is most effective when combined with rational decision-making.

Rational investors will direct their investments so that the net benefit from their scarce investment funds will be maximized.

According to the principle of marginalism: Invest in a particular activity whenever the marginal benefit

exceeds the marginal cost of the investment. Invest up to the point where the marginal benefit just

equals the marginal costs.

What is Economics?

How do humans cooperate when confronted by scarcity?

Construct Institutions1. Families (households)2. Governments3. Private Enterprise (firms)

Participate in Markets where they can enter into voluntary agreements to exchange goods and services that make both better off.

What is Economics?

Because of scarcity, Institutions (families, firms and governments) use rational decision-making and investment to efficiently employ their scarce resources in a manner which best promotes their interests.

All institutions engage with each other through markets. For example: A family enters the housing market to buy a house. The

size of this investment is rationally chosen to best promote the interests of the family. They enter the financial capital market to get a mortgage loan sufficient to buy the house. To pay for the interest on their loan, household members sell their labour in the labour market.

What is Economics?

An economy is defined by the mixture of institutions and markets that has been adopted to organize cooperation.

A society’s economy determines: What is produced How it is produced Who receives what is produced (Distribution)

What is Economics?

Do humans always cooperate in the same way?

Hunter gatherer economies (Families are Dominant Institution)

Feudal economies (The State is the Dominant Institution)

Centrally planned or command economies (The State is the Dominant Institution)

Capitalist economies (The Market Is the Dominant Institution)

Mixed economies (Markets and Democratic Government Dominate to Varying Degrees)

What is Economics?

Humans have invented many different types of economies to foster cooperation.

No economy has defeated scarcity. No amount of science and economic growth will

ever defeat scarcity so long as humans remain insatiable.

The idealism in socialist and green political philosophy often hinges on the creation of a new sort of human being that does not suffer from greed.

Economists are deeply sceptical.

What is Economics?

What kind of economy does Canada have? Canada has a mixed economy in which markets

organize most economic activity, yet governments intervene with command mechanisms to alter market outcomes.

For example, the government of Canada expropriates income using taxation and uses this revenue to: fund public services that might not be available in the

market and to fund transfers to the poor.

What is Economics?

Canada’s economy is also an open economy in which Canadian households and firms are connected to households and firms throughout the world by international markets.

Globalization has increased the degree of openness and has fostered the development of transnational institutions: Multinational Corporations United Nations World Bank / International Monetary Fund/Kyoto / WTO /

etc.

Two Big Economic Questions Some economic questions to consider:1. How does our mixed economy work?2. Can it be reorganized to make our society better?3. Does further globalization help or hurt our society?4. Can we respond positively to the challenges of

global warming, natural resource depletion, widespread poverty in the developing world, …

5. What does the economic rise of India and China mean for Canadian society?