The Art and Science of Economics


Published on

Published in: Technology, Economy & Finance
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

The Art and Science of Economics

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