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The Art and Science of Economics
Chapter 1
© 2006 Thomson/South-Western
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The Economic Problem
Economics examines how people use their scarce resources to satisfy their unlimited wants
Scarce resource Not freely available when its price exceeds zero
Resources Inputs Factors of production Used to produce goods and services
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Resources
Goods and services are scarce because resources are scarce
Four general categoriesLaborCapitalLandEntrepreneurial Ability
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Labor and Capital
Labor: broad category of human effort Physical and mental Time Scarcity of time scarcity of labor
Capital: Human creations used to produce goods and services Physical capital: factories, machines, tools,
buildings, airports, highways and other manufactured items employed to produce goods and services
Human capital: consists of the knowledge and skill people acquire to enhance their labor productivity
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Land &Entrepreneurial Ability
LandLand and other natural resourcesGifts of nature including bodies of water,
trees, oil reserves, etc.
Entrepreneurial AbilitySpecial kind of human skillTalent required to dream up a new product
or find a better way to produce an existing one
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Payments for Resources
Wages payment for use of labor
Interest payment for the use of capital
Rent payment for use of land
Profit reward for entrepreneur’s reward
Revenue from sales minus cost of resources employed Claims what is left over after paying for other resources
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Goods and Services
Goods Tangible items
Services Intangible items
Good or service is scarce if the amount people desire exceeds the amount that is available at a zero price we must continually choose among them Choices in a world of scarcity implies we must pass up some
goods and services
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Free Goods
Goods that are available at a zero price
Even these goods may come with strings attached
For example, while air and seawater may appear to be free, clean air and seawater have become scarce
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Economic Decision Makers
Four types of decision-makers in the economy Households
Demand the goods and services produced Supply labor, capital, labor, and entrepreneurial ability
Firms, governments, and the rest of the world Demand the resources Supply the goods and services Rest of the world foreign households, firms and
governments
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Markets
Means by which buyers and sellers carry out exchanges
Product markets Markets in which goods and services are bought and
sold
Resource Markets Markets in which the resources are exchanged Labor, or job, market is the most important of the
resource markets
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Exhibit 1: Circular-Flow Model
Households supply resources in the resource market and demand goods and services in the product marketFirms supply goods and services in the product market and demand resources in the resource marketMoney flows in resource markets determine wages, interest, rents and profits which flow as income to householdsProduct markets determine the prices for goods and services which flow as revenue to firms
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Rational Self Interest
Maximizing the expected benefit achieved with a given cost or minimizing the expected cost of achieving a given benefit
Self Interest
Rational – people try to make the best choices they can, given the available information
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Time and Information
Time and information are both scarce and valuable
Often willing to pay others to gather and digest it for us
Decision-makers will continue to acquire information as long as the additional benefit expected from that information exceeds the additional cost of gathering information
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Marginal Analysis
Comparison of expected marginal cost and the expected marginal benefit of the action under consideration
MarginalIncrementalAdditionalExtra
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Micro and Macro “economics”
MicroeconomicsExamines the factors that influence individual
economic choices Studies the individual pieces of the economic
puzzle
MacroeconomicsStudies the performance of the economy as a
wholeFocuses on the big picture
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Science of Economic Analysis
Economic theory or model
Simplification of economic reality
Used to make predictions about the real world
Focuses on the important elements of the problem under study
More details more unwieldy
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Exhibit 2 The Scientific Method1. Identify the Question and Define Relevant Variables
2. Specify Assumptions
or
3. Formulate a hypothesis
4. Test the hypothesis
Reject the hypothesis
Use the hypothesis until a better one shows up
Modify Approach
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Scientific Method
Identify the Question and Define the relevant variables Variable is a measure that can take on different
values
Specify Assumptions Other-things-constant assumption: ceteris paribus Behavioral Assumption refer to how people behave
rational self-interest consumers maximize satisfaction and firm maximizes profits
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Formulate and Test Hypothesis
Statement about how the key variables relate to each other
Provides the predictions of interest based on cause and effect relationships
Test involves comparing these predictions with real world
This is where the validity of theory is tested
We reject the theory if it predicts worse than the best alternative
We accept the theory until a better one comes along
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Normative versus Positive
Positive economic statementAssertion about economic realitySupported or rejected by reference to the
facts
Normative economic statementOpinionsCannot be shown to be true or false by
reference to the facts
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Predicting Average Behavior
Because the unpredictable actions of numerous individuals tend to cancel one another out, the average behavior of a group of individuals can be predicted more accurately than the actions of any one individual
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Pitfalls of Economic Analysis
Three possible sources of mistakes in reasoning leading to faulty conclusions
Fallacy that Association is Causation
Fallacy of Composition
Mistake of Ignoring Secondary Effects
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Pitfalls of Economic Analysis
Fallacy that Association is Causation Event A caused event B simply because the two are
associated in time The fact that one event precedes another or that the
two events occur simultaneously does not necessarily mean that one event caused the other
Fallacy of Composition Erroneous belief that what is true for the individual
or the part, is also true for the group, or the whole
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Ignoring Secondary Effects
Unintended consequences of policies or choices
Primary Effects Effects that are felt relatively quickly Easily observed
Secondary Effects Tend to develop more slowly Frequently not obvious
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