Unit 1: The Scope and Method of Economics [INLINE] UNDER CONSTRUCTION
Read "Case and Fair": Chapter 1 - pages 1-20.
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A. Definition of Economics
Economics is 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 science.
In large measure it is the study of how people make choices.
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B. Why study economics?
1. To learn a way of thinking: This summer we are going to learn to
think like economists - to use tools that will help us analyze
complex situations in the real world of economics.
2. To understand society: Past and present economic decisions have
an influence on the character of life in a society.
3. To understand global affairs: Understanding international
relations begins with knowledge of the economic links among
countries.
4. To be an informed voter: When you participate in the political
process, you are voting on issues that require a basic understanding
of economics.
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C. The difference between micro and macro economics
Microeconomics deals with the functioning of individual industries
and the behavior of individual economic decision-making units -
business firms and households. It explores the decisions that
individual businesses and consumers make - firms' choices about what
to produce and how much to charge, and households' choices about
what and how much to buy.
Macro economics looks at the economy as a whole. Instead of trying
to understand what determines the output of a single firm or
industry, or the consumption patterns of a single household or group
of house holds, it examines the factors that determine national
output and income.
While micro economics focuses on individual product prices, macro
economics looks at the overall price level and its behavior over
time.
Micro economics questions how many people will be hired or laid off
in a particular industry and the factors that determine how much
labor a firm or industry will hire. Macro economics deals with
aggregate employment and unemployment: how many jobs exist in the
economy as a whole, and how many people are willing to work but
unable to find jobs..
We are going to be using this word "aggregate" a lot. It refers to
the behavior of firms and households taken together. For example,
aggregate consumption refers to the consumption of all the
households in the economy; aggregate investment refers to the total
investment made by all firms in the economy.
There are some topics which micro and macro economics share.
For example, the study of how government policy affects the economy.
However, again micro economics looks at these effects on the level
of the individual firm or household, macro economics considers the
effects of policy on the economy as a whole..
The micro economic foundations of macro economics.
There is also another important relationship between the two
branches of economics and this is what is called the micro economic
foundations of macro economics. This is a fairly new development and
one which is trying to reconcile the assumptions and principles of
micro economic analysis with efforts to understand the economy as a
whole.
For example, in efforts to understand inflation, macro economists
are now trying to include micro economic ideas about the way that
prices adjust to changes in supply and demand..
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D. The relationship between economics and social philosophy. One of
the first economists was an Englishman by the name of Adam Smith.
(Some would say he was the first economist.)
Born in the early part of the 18th century, Smith developed the idea
of the "invisible hand" and was the first to describe the
relationship between supply and demand in a free market economy. He
described himself as a "social philosopher".
Social philosophy is concerned with fairness. It deals with
questions such as:
Why are some people rich and others poor?
Is it fair that 90% of the country's wealth is controlled by 5% of
the population?
Is the progressive income tax, which taxes a higher proportion of
the income of the wealthy, fair?
These questions are still relevant and are the subject of economic
policy.
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E. Economic Policy
A policy is a plan that guides action.
An example of an economic policy would be the Federal government's
plan to keep the economy working at full employment.
Anyone can recommend macro economic policies but it is up to
governments to implement them.
In general we judge the outcomes of any policy according to four
criteria:
1. Efficiency: In economics we say that a policy is efficient if it
leads to outcomes that help the economy produce what people want at
the least possible cost.
2. Equity or fairness: This is obviously hard to define because
fairness like beauty depends on who's looking, but in general terms
we could say that an economic policy is fair if it leads to outcomes
in which the costs and benefits are shared in a way that is
proportional to a person's participation.
3. Growth: At the present time economic policies are also judged
according to whether or not they lead to increases in output. I say
"at present" because some economists are beginning to question the
assumption that economic growth is always a good thing.
4. Stability: In economics stability is defined as the condition of
the economy in which output is growing at a steady rate, with low
inflation and full employment. Currently, the Federal Reserve is
defining stability as a growth rate of about 3%, with inflation
between 2% and 3% and unemployment between 5% and 6%.
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F. What economists do. In addition to making policy recommendations,
economists spend a lot of time formulating theories and developing
models. These two words have more or less the same meaning in
economics that they do in other academic disciplines.
A theory is a coherent set of hypotheses which make statements about
the way the world works.
To illustrate this idea of theory, the text refers to what is known
as "the law of demand". This so-called law is really just a
well-tested hypothesis which states that when prices fall, people
tend to buy more, and vice versa.
A theory is said to be "good" if its hypotheses turn out to valid
statements about the real world and if it has predictive power.
I should say at this point that very few economic theories,
particularly in macro economics, have predictive power.
A model is just a formal statement of the theory, usually a
mathematical statement.
Several institutions have built huge models of the US economy and
how it works that have hundreds of equations linked together. These
big models usually run on computers. When we visit the Federal
Reserve in San Francisco we will see one of these models in action.
We will also be working with a number of smaller models and a large
number of pictures of models.
The text points out two common errors that are made when people
develop theories or build models. These are:
1. The post hoc fallacy: This mistake is made when someone mistakes
an association between two variables for a cause and effect
relationship. My favorite example of this is taken from a study done
in Holland at the end of WWII which showed a positive relationship
between the number of storks inhabiting a certain city and the
number of babies born.
2. The fallacy of composition: This has to do with the belief that
what is true for the part is also true for the whole. There are many
examples of this kind of thinking in economics. For example, we have
seen over a very long period of time the benefits of free markets -
the efficiencies in individual markets that are created whenever
people are free to pursue their own self-interest. However, it might
be a mistake to assume that pursuit of one's own self interest was
the best thing for society as a whole.
You cannot prove a theory.
It is important to note that neither theories nor models can ever be
proved beyond the shadow of a doubt. The best we can say of a theory
is that it is consistent with the facts as currently observed and
that it is seems to have predictive power.
Another fact about theories is that they are always based on certain
assumptions which have to be accepted for the theory to work.
For example, in economic theory two of the most important
assumptions are (1) that people make rational choices based on
analyzing costs and benefits and (2) that people try to maximize
utility.
Another important assumption that is rarely discussed is that the
world of economics can be understood by understanding the behavior
of discrete variables.
All of these assumptions are now under attack.
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G. Other Important Concepts Introduced in Chapter 1
1. Opportunity Cost: This can be understood as the cost of lost
opportunities. An example would be the opportunity cost of coming to
Skyline this summer. This cost is measured by the wages I could have
been earning if I had decided to work instead.
The reason that opportunity costs exist is because resources are
scarce; it is an especially important concept in economics where we
are often trying to measure the costs and benefits of different
economic choices, policies, etc.
2. Marginal: This refers to the "last unit" and is also an important
factor in making economic choices.
For example, suppose the publisher of our textbook is trying to
calculate the costs of producing more books. In making this
calculation, Prentice Hall would only consider the marginal or
additional costs of just these new books. The money they have
already spent would be irrelevant. These are the sunk costs and even
though they would be included in a calculation of average costs,
they wouldn't influence the decision to produce additional books.
3. Markets - free and regulated, efficient and inefficient:
Markets can be free or regulated, efficient or inefficient. Most
markets in the real economy represent some combination of these
qualities.
A market is said to be free if buyers and sellers are free to come
together and make deals without government interference.
A regulated market is one where the government sets at least some of
the rules.
For example, the stock market is relatively free - people can buy
and sell shares of stock without much interference from the
government. However, the Securities and Exchange Commission
establishes many rules in this market, particularly for companies
who wish to sell their stock.
An efficient market is one in which there is a very rapid
circulation of information and in which profit opportunities are
grabbed up almost as soon as they appear. Inefficiencies arise
wherever the flow of information is restricted and where people are
not free to take advantage of profit opportunities.
4. Ceteris Paribus: This is a Latin phrase which mean "all else
equal" and refers to the difficulty of analyzing more than two
variables at a time. It is trotted out by economists when they want
to emphasize the fact that they are looking at a single
relationship, holding everything else constant. For example, "The
amount of a good or service that people want is inversely related to
the price, ceteris paribus."
The things that are held constant in this example are the tastes and
preferences of consumers, the availability of substitutes etc.
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