Unit 1: The Scope and Method of Economics [INLINE] UNDER CONSTRUCTION Read "Case and Fair": Chapter 1 - pages 1-20. _________________________________________________________________ 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. _________________________________________________________________ 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. _________________________________________________________________ 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.. _________________________________________________________________ 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. _________________________________________________________________ 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%. _________________________________________________________________ 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. _________________________________________________________________ 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. [LINK] Return to Econ 100 Home page [LINK] Problem Set for Unit 1