The Economic Way of Thinking


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For all those interested in "The Economic Way of Thinking" - my new infoposter "ECONOMICS" is now available:

- the poster gives an overview of the development of economic theory from its beginnings.

- the poster shows the historical roots of economic ideas and their application to contemporary economic policy debates.

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Martin Kolmhofer

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The Economic Way of Thinking

  1. 1. The Economic Way of Thinking
  2. 3. What is economics all about?
  3. 5. It´s all about people…
  4. 6. Unlimited Wants: More Time, More Fun, More Choices… (Only perfect beings want nothing) Limited Resources: Time, Energy, Money,…
  5. 7. Choices must be made…
  6. 8. <ul><li>ECONOMICS is the study of how people chose to use their scarce resources in an attempt to satisfy their unlimited wants </li></ul>
  7. 9. <ul><li>SCARCITY exists when there is not enough of something (product/service/resource) to satisfy everyone’s wants AT A ZERO PRICE </li></ul>
  8. 10. How to distribute resources rationally in the economy? Capitalist solution is the Price Mechanism Those who are willing to pay the price will get the goods and services
  9. 11. VIDEO: The Price Mechanism in Action
  10. 12. Example: Supply of a big city. Who coordinates? NOBODY Process of impersonal social interaction is coordinated through prices Prices are signals that tell us what we have to do in order to be useful for other people - This is how it was possible to create a society based on the division of labour Millions of people in society coordinate their plans through markets
  11. 13. Recognizing Order
  12. 14. The Importance of Social Cooperation <ul><li>Is cooperation/civilization something “natural”? </li></ul><ul><li>Thomas Hobbes (1588-1679): Leviathan(1651) </li></ul><ul><li>In the absence of a system for enforcing order in society, life will be “solitary, poor, nasty, brutish and short” </li></ul><ul><li>Abstention from violence and robbery vs. Positive Cooperation (will it develop automatically? Why should it?) </li></ul><ul><ul><li>Whatsoever therefore is consequent to a time of Warre, where every man is Enemy to every man; the same is consequent to the time, wherein men live without other security, than what their own strength, and their own invention shall furnish them withall. In such condition, there is no place for Industry; because the fruit thereof is uncertain; and consequently no Culture of the Earth; no Navigation, nor use of the commodities that may be imported by Sea; no commodious Building; no Instruments of moving, and removing such things as require much force; no Knowledge of the face of the Earth; no account of Time; no Arts; no Letters; no Society; and which is worst of all, continuall feare, and danger of violent death; And the life of man, solitary, poore, nasty, brutish, and short. (Leviathan 1651 Pt. I, Ch. 13) </li></ul></ul>
  13. 15. How Does it Happen? <ul><li>How do people encourage one another to take precisely those complexly interconnected actions that will eventually produce the multitude of goods and services that we all enjoy? </li></ul><ul><li>Even a society of saints must use some procedures for inducing positive cooperation of the right kind . </li></ul><ul><li>How are countless individuals led to do the “right thing” without ever caring about doing good? </li></ul>
  14. 16. Adam Smith (1723 – 1790) was the first economist who investigated how this process of social coordination works: Rational, self-interested behaviour does not produce chaos, but usually produces social coordination
  15. 17. The Economic Way of Thinking <ul><li>All social phenomena result from interactions among the choices that individuals make after calculating the expected benefits and costs to themselves </li></ul><ul><li>Economics studies all kind of choices and the unintended consequences of choices. </li></ul>
  16. 18. Cooperation Through Mutual Adjustment Your choices and plans change the opportunities available to others and social coordination is a process of continuing mutual adjustment to the changing net advantages that their interactions generate. Example: Freeway – smoothly coordinated flow Drivers will disperse themselves evenly over the lanes. Why? Drivers are alert of the net advantages of each lane and therefore try to move out of any lanes that are moving slowly and into those that are moving faster. This speeds up the slow lanes and slows down the fast lanes until all lanes are moving at the same rate (until no driver perceives any net advantage to be gained by changing lanes) It all happens quickly, continuously, and far more effectively than if someone at the entrances passed out tickets assigning each vehicle to a particular lane.
  17. 19. Cooperation Through Mutual Adjustment The same basic principles are at work in the rest of society. Individuals chose their actions on the basis of the net advantages they expect. Their actions alter, however minutely, the relative benefits and costs of the options that others perceive. When the ration of expected benefit to expected cost for any action increases, people do more of it. When the ratio falls, they do less. The fact that almost everyone prefers more money to less is an enormous aid in the process, an extremely important lubricant, if you will, in the mechanism of social coordination. Modest changes in the monetary cost and monetary benefit of particular options can induce large numbers of people to alter their behavior in directions more consistent with what other people are currently doing. And this is the primary system by which we obtain cooperation among the members of society in using what is available to provide what people want. This is what the market economy is all about.
  18. 20. Rules of the Game Whether the “game” is business, government, science, family, school, traffic, it can’t be played satisfactorily unless the players know at least roughly what the rules are and generally agree to follow them. Examples: CEE Transition Traveling abroad (people do not know exactly what is expected of them or what they can expect from others) If rules are absent or suddenly upset: Social Cooperation can fall apart quickly
  19. 21. Property Rights as Rules of the Game <ul><li>Property Rights are a major part of the „rules of the game“ which govern economic activity </li></ul><ul><li>A market exchange economy is based on private property rights (legal ownership) </li></ul><ul><li>Private property rights can be voluntarily traded or exchanged </li></ul>
  20. 22. Questions for Discussion: <ul><li>What would you predict would happen if planners in Prague decided to reserve one lane of its freeways for „urgent vehicles“, with an urgent vehicle defined as any vehicle whose driver might be late for an important event if the vehicle were to be delayed by congestion in the regular lanes? Do you think drivers would stay out of the urgent vehicles lane? Or would it become just as congested as all the other lanes? </li></ul>
  21. 23. Questions for Discussion: <ul><li>Have you ever noticed that the grounds of city-owned parks are often more polluted than those of country clubs? </li></ul><ul><li>Is it simply because people who use parks are less concerned with pollution compared to those who golf? Is that even true? </li></ul><ul><li>Might the property-rights assignment have something to do with it? Who owns the city club? Who owns the country club? </li></ul>
  22. 24. Appendix 1 Micro vs. Macro
  23. 25. If economics is simply an issue of examining how people chose to use this many resources to satisfy this many wants…. … why do we have both Microeconomics and Macroeconomics?
  24. 26. Its simply a question of scope. Microeconomics deals with choices of a single entity . (One product, one price, one consumer, one household, one business, or even one industry.)   Macroeconomics on the other hand deals with the actions of the economy as a whole. The country´s income (which we call GDP), all prices (or inflation), or unemployment across the entire economy….
  25. 27. Appendix 2 Positive vs. Normative Analysis
  26. 28. It is crucial that you can distinguish between positive and normative analysis. Positive analysis is factual analysis. You can recognize a positive statement because it can be tested, it can be proven or disproven. There are no personal judgments involved.
  27. 29. For example, I could tell you that it’s 72 degrees outside today. You could verify that my statement is true or untrue
  28. 30. Normative Analysis on the other hand is opinion-based analysis. You can recognize a normative statement because it involves personal judgments and ideals that cannot be proven or disproven.
  29. 31. What if I tell you that ORANGE is better than RED Can you verify this? Can you test it? Can you prove it or disprove it?
  30. 32. In the end we need both types of analysis to make policy. The Think Tank groups engage in positive analysis, then turn the finance over to the policy makers who use this information to create policies that they feel are best for society. If you happen to disagree with their policies then you can vote for someone else... Exercise: Take a look at a headline from today’s news. Can you distinguish the positive statements from the normative statements?
  31. 33. “ Robinson Crusoe” Economics
  32. 34. • How even a one-man economy illustrates economic concepts and categories. • The importance of saving and investment. • How economists explain individual choices. In this lesson you will learn:
  33. 35. Before we can analyze an economy composed of billions of interacting people, we should start with just one person and make sure we understand what makes him tick. We are developing general principles about an individual’s purposeful actions in the face of scarcity.
  34. 36. Crusoe feels uneasy – decides to take action: Before he can make a sensible decision on how to proceed, Crusoe first needs to see what he has to work with: Economic Goods (Coconuts, Rocks…) Scarce physical items or services that directly satisfy a person’s preferences – as opposed to Free Goods (Air, Gravity…). Crusoe needs to economize his consumer goods (treating a resource with care because it is scarce and can only satisfy a limited number of goals or preferences.) Tradeoffs: Until he finds another source of food (such as fish after he constructs some tools), Crusoe needs to make sure he doesn’t eat his coconuts too quickly. If he decides to use certain rocks in order to make a shelter, Crusoe can’t simultaneously use those same rocks when building a fire. It’s important to realize that an object becomes a good when a person incorporates it into his plans. i.e. “Crusoe Creates Goods With His Mind Powers” For example, certain plants on the island might have medicinal properties, but if Crusoe doesn’t know it, then those plants will not attain the status of economic goods. Economic Goods vs. Free Goods
  35. 37. Now that we understand what goods are in general, we can begin to make some distinctions. On the one hand, Crusoe recognizes that there are scarce items that can help him to directly achieve his goals. For example, the running water in the stream can directly quench his thirst, and the coconuts can directly satisfy Crusoe’s hunger. Economists call these consumer goods . On the other hand, there are items that are certainly useful, and which would allow Crusoe to achieve more of his goals if he had more such items— hence they are goods—but they are not directly useful to him. They are only indirectly useful because they help Crusoe to obtain more consumer goods. Economists call such items producer goods or factors of production or means of production. For example, a long stick, in and of itself, doesn’t do anything for Crusoe, and if it were the only object on the island, Crusoe would not consider it a good at all. But because there are coconuts hanging on trees—some of which are out of Crusoe’s reach—suddenly the stick acquires value indirectly. Crusoe now considers the stick to be a good, even though it doesn’t directly satisfy hunger, because it indirectly helps him to achieve his goal. Consumer Goods vs. Producer Goods
  36. 38. Land, Labor, and Capital Goods Land: direct gifts of nature (flowing stream, trees…) Labor: productive services Crusoe performs with his body Capital Goods are those factors of production that were created by people (fishing net, shelter…) Types of Producer Goods
  37. 39. Income, Saving and Investment <ul><li>Factor TIME </li></ul><ul><li>Income : The flow of consumer goods and services that a person has the potential to enjoy during a specific period of time. </li></ul><ul><li>Saving : Consuming less than one’s income would allow; living below one’s means. </li></ul><ul><li>Investment : Diverting resources into projects that are expected to increase future income. </li></ul><ul><li>Example (from hand-to-mouth existence to increased productivity) </li></ul>One of the most important decisions a person makes is whether to devote time and other resources to the present or to the future. Through saving and investment, people sacrifice current enjoyments but achieve much greater enjoyments in the future.
  38. 40. Marginal Utility – Goods are valued unit by unit <ul><li>Water – Diamond Paradox </li></ul><ul><li>Subjective Value Theory vs. Labor Theory of Value (Menger, Walras, Jevons) </li></ul><ul><li>Law of diminishing marginal utility : the first unit of consumption of a good or service yields more utility than the second and subsequent units. </li></ul><ul><li>This principle of valuing goods by individual units applies in Robinson Crusoe’s world. </li></ul>
  39. 41. Opportunity Costs When Crusoe makes a choice, he can’t simply consider the benefits, as he subjectively perceives them. He must also consider the costs. The cost of a particular decision is the value that Crusoe places on the most important goal that he won’t be able to achieve, because of the decision. Economists use the term opportunity cost , which they define as the subjective value placed on the next-best alternative that must be sacrificed because of a choice.
  40. 42. Expectations <ul><li>Crusoe’s actions are guided by his expectations, which is to say his predictions about the future. </li></ul><ul><li>Expectations = An individual’s forecasts of the future, which involve his or her understanding of “how the world works” and therefore guide current actions. </li></ul>For example, Crusoe might spend several weeks collecting branches and other materials, in order to construct a raft. He thinks he will be able to use it to escape to the high sea, where he hopes someone will rescue him. The benefits of this small chance of escape are more important to Crusoe than the leisure he is giving up during the construction of the raft. However, after many attempts, Crusoe realizes that the ocean won’t let him escape the island on his raft. Unfortunately, he can’t find anything on his island that would serve as a large sail. He realizes with great regret that his efforts on the raft were a complete waste of time. Or more accurately, a complete waste of leisure. Despite Crusoe’s mistake, as economists we still explain his original choices by saying that Crusoe considered the benefits of getting out to sea to be greater than the cost of many hours of leisure. Even though this wasn’t the true tradeoff involved, Crusoe believed that it was, and it is ultimately Crusoe’s beliefs (and preferences) that guide his decisions.