Eco104 lecture slide

1. 1
WHAT ECONOMICS IS ABOUT

2. I. Introduction
A Definition of Economics
Economics is a social science that deals with efficient
and “equitable” (?) allocation of scarce resources
Economics is the social science that studies the
choices that individuals, businesses, governments,
and societies make as they cope with scarcity and the
incentives that influence and reconcile those choices.

3. Definition of Economics
Scarcity
All economic questions arise because we are unable to
satisfy all our wants—because we face scarcity.
Society’s wants exceed the resources available to satisfy
them.
Rich and poor alike are faced with scarcity.

4. Definition of Economics
Incentives
Everyone responds to incentives. In general there is some
sort of incentive behind everything an individual does.
Without proper incentives in place, it’s hard to motivate
anyone to do anything: Market economy vs. Planned
economy
To solve any problem, policymakers should think hard
before making an incentive design – otherwise, it may
backfire.

5. Definition of Economics
Microeconomics
Microeconomics is the study of choices made by
individuals and businesses, and the influence of
government on those choices.
Micro = small
Macroeconomics
Macroeconomics is the study of the effects on the
national and global economy of the choices that
individuals, businesses, and governments make.
Macro = big

6. Three Big Microeconomic Questions
Microeconomics seeks to understand what determines:
▪ What goods and services are produced – which and how
much of each;
▪ How goods and services are produced;
▪ For whom goods and services are produced;
Goods and services are the things that people value so
produce to satisfy wants – their own and others’.

7. Three Big Microeconomic Questions
What Goods and Services
are Produced?
Agriculture accounts for less
than 1 percent of total U.S.
production, manufactured
goods for 22 percent, and
services for 77 percent.
In China, agriculture
accounts for 11 percent of
total production,
manufactured goods for 47
percent, and services for 43
percent.

8. What Goods and Services are Produced?
Three Big Microeconomic Questions
Share of Agricultural and Manufacturing sectors in GDP of Bangladesh

9. Three Big Microeconomic Questions
The facts about what we produce raise the deeper question:
What determines the quantities of, say, realtor services, new
homes, DVD players, or corn that we produce?
Microeconomics provides some answers to these questions.

10. Three Big Microeconomic Questions
How are Goods and Services Produced?
Factors of production are the resources, or “primary
inputs” that we use to produce goods and services.
They are grouped into four categories:
▪ Land
▪ Labor
▪ Capital
▪ Entrepreneurship

11. Three Big Microeconomic Questions
The “gifts of nature,” i.e. all natural resources, that we use to
produce goods and services are land.
The work time and effort that people devote to producing goods
and services is labor. The quality of labor depends on human
capital, which is the knowledge and skill that people obtain
from education, on-the-job training, and work experience.
The tools, instruments, machines, buildings, and other man-
made durable, physical, things that are used to produce goods
and services are capital.
The human resource that organizes land, labor, and capital, and
bears the risks involved, is entrepreneurship. The reward for
organization and risk-bearing is profit [or loss!]

12. Three Big Microeconomic Questions
The facts about how we produce raise the deeper
question: What determines the quantities of capital, labor,
and other inputs that get used to produce each good or
service?
Microeconomics provides some answers to this question.

13. Three Big Microeconomic Questions
For Whom are Goods and Services Produced?
Who gets the goods and services depends on the incomes
that people earn, and what they want.
▪ Land earns rent.
▪ Labor earns wages.
▪ Capital earns interest.
▪ Entrepreneurship earns profit.

14. Three Big Microeconomic Questions
The facts about for whom raise the deeper question:
What determines earnings and the distribution of
income that in turn determine who gets the goods and
services produced?
Microeconomics provides some answers to this
question.
World's eight richest people have the same wealth
as the poorest 50% (Source: OXFAM, 2017)

15. Three Big Microeconomic Questions
• Inequality in the U.S. is much larger than that in Bangladesh.
• Income inequality has increased both in the U.S. and
Bangladesh over the 31-year period.
Income Share of Rich vs. Poor in Bangladesh vs USA
Source: https://data.worldbank.org/
Country Year Income share
held by the
Richest 10%
(R10)
Income share
held by the
poorest 10%
(P10)
Bangladesh 1985 23.4% 4.5%
2016 26.8% 3.7%
USA 1985 26.8% 1.9%
2016 30.6% 1.7%
R10/P10
5.2
7.2
14.1
18

16. Three Big Macroeconomic Questions
Macroeconomics focuses on three big questions:
▪ What determines the standard of living?
▪ What determines the cost of living?
▪ Why and how does our economy fluctuate?

17. Three Big Macroeconomic Questions
What Determines the Standard of Living?
The standard of living is the level of consumption that people enjoy on
average. It is usually measured by average income per person.
According to PWT 9.0, in 1985, the average income per person (PPP-
adjusted, yearly) in the richest 5% of the countries in the world was 35
times that of the poorest 5%. In the sample of 115 countries (oil based
economies have been omitted from the richest 5%; and countries with
population less than 1 million have been omitted from the sample):
–The richest 5%: U.S.A., Switzerland, Norway, Canada, Australia and Sweden
–The poorest 5%: Ethiopia, Liberia, Cambodia, Uganda, Mali, Mozambique

18. In 2014, the average income per person (PPP-adjusted, yearly) in the richest 5% of the countries
in the world was 61 times that of the poorest 5%. In the sample of 143 countries (oil based
economies have been omitted from the richest 5%; and countries with population less than 1
million have been omitted from the sample):
The richest 5%: Norway, Singapore, Switzerland, U.S.A., Ireland, Netherlands, Germany
The poorest 5%: Mozambique, D. R. Congo, Malawi, Niger, Liberia, Burundi, Central African
Republic
Poorest country: Central African Republic, Income per person : $600 / year
The richest country: Norway, Income per person: $78,293 / year
The Position of Bangladesh:
116-th, Income per person: $2,917 / year
≈ BDT 20,000/month
Without PPP-adjustment, average income per person:
Around BDT 7,000/month
Three Big Macroeconomic Questions

19. Macroeconomics seeks to explain differences in the
standard of living across countries.
Macroeconomics also seeks to explain the rate at which
the standard of living changes.
Three Big Macroeconomic Questions

20. Three Big Macroeconomic Questions
What Determines the Cost of Living?
The cost of living is the amount of money it takes to buy
the goods and services that a typical family consumes.
The cost of living in the United States is the number of
dollars it takes to buy the goods and services that a typical
family consumes.
The cost of living in Bangladesh is the number of takas it
takes to buy the goods and services that a typical family
consumes.
What matters mostly is the rate at which prices change.

21. Three Big Macroeconomic Questions
A rising cost of living is called inflation.
A falling cost of living is called deflation.
Inflation brings a shrinking value of taka and deflation
brings a rising value of taka.
Macroeconomics seeks to explain the forces that
determine the cost of living and the inflation (or deflation)
rate.

22. Three Big Macroeconomic Questions
Why Does Our Economy Fluctuate?
The business cycle is the periodic but irregular up-and-
down movement in production and jobs in an economy.
During 2007-08, the U.S. economy entered a recession—
production and jobs shrank.
During the 1990s, the U.S. economy enjoyed a prolonged
expansion—production and jobs increased.
The Figure on the next slide illustrates the stylized phases
and turning points of a business cycle.

23. Three Big Macroeconomic Questions

24. Three Big Macroeconomic Questions
Data source: U.S. Department of Commerce Bureau of Economic Analysis
0
2000
4000
6000
8000
10000
12000
14000
16000
2000 2002 2004 2006 2008 2010 2012
U.S. GDP (Quarterly, Billion 2005 USD)

25. Three Big Macroeconomic Questions
Data source: U.S. Department of Commerce Bureau of Economic Analysis
U.S. GDP (Quarterly, Billion 2005 USD)
0
2000
4000
6000
8000
10000
12000
14000
16000
2000 2002 2004 2006 2008 2010 2012
GDP Trend GDP

26. Three Big Macroeconomic Questions
-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
2000 2002 2004 2006 2008 2010 2012
The U.S. Business Cycle (2000-2012)

27. Three Big Macroeconomic Questions
Why Does Our Economy Fluctuate?
Economists remain unsure about the sources of economic
fluctuations and about the actions that might be taken to
smooth the economy.
But in your study of macroeconomics, you will learn some
of what economists have discovered about economic
fluctuations.

28. The Economic Way of Thinking
Choices and Tradeoffs
The economic way of thinking places scarcity and its
implication, choice, at center stage.
You can think about every choice as a tradeoff—an
exchange—giving up one thing to get something else.
A classic tradeoff is “guns versus butter.”
“Guns” and “butter” stand for any two objects of value.

29. The Economic Way of Thinking
Microeconomic Tradeoffs
The three microeconomic questions become sharper
when we think in terms of tradeoffs.
“What?” Tradeoffs arise when people choose on what to
spend their incomes, when governments choose on what
to spend their tax revenues, and when businesses choose
what to produce.

30. The Economic Way of Thinking
Microeconomic Tradeoffs
“How?” Tradeoffs arise when businesses choose among
alternative production technologies.
“For Whom?” Tradeoffs arise when choices change the
distribution of buying power across individuals.
Government redistribution of income from the rich to the
poor creates the big tradeoff—the tradeoff between
equality and efficiency. Equity [fairness] and efficiency
are two classic ways to judge economic decisions.

31. The Economic Way of Thinking
Macroeconomic Tradeoffs
Standard of Living Tradeoffs arise when we choose
between current consumption and activities that we hope
will increase our standard of living in the future.
Activities such as saving and investing, education, and
research should increase future production and
consumption possibilities, which permit increases in the
standard of living.

32. The Economic Way of Thinking
Macroeconomic Tradeoffs
An Output-Inflation Tradeoff arises when policymakers
choose how much inflation to endure in order to maintain a
high level of production.
An output-inflation tradeoff arises if a policy action that
lowers inflation also lowers output, or a policy action that
boosts output increases inflation. Unfortunately, this is
often the case.

33. The Economic Way of Thinking
Opportunity Cost
Thinking about a choice as a tradeoff emphasizes cost as
an opportunity forgone.
The highest-valued alternative that we give up to get
something is the opportunity cost of the activity chosen.
There Is No Such Thing As A Free Lunch.

34. The Economic Way of Thinking
Opportunity Cost
Consider people who speak about free housing, free
bridges (“no charge to cross it”), and free parks. None of
these things are actually free. The resources that provide
housing, bridges, and parks could have been used in
other ways.
If it is not qualified by anything else, in economics “cost”
always means opportunity cost. This is an example of
jargon.

35. JARGON
Economics uses jargon a lot
Jargon means a special vocabulary
Economics jargon can be confusing
because it often gives special meaning to
ordinary, every day words, that have a
different meaning in normal usage

36. Why jargon?
Jargon allows precision
Jargon allows shorter statements
Jargon permits more efficient
communication
It’s standard in economics, so we have to
know it to understand economics

37. Quote: Joan Robinson
[Professor of Economics at U. of Cambridge]
“You study economics in
order to avoid being fooled by
economists”

38. Bad aspects of Jargon
Jargon can be used to make things ambiguous
Jargon can be confusing to those who are unsure of it
Unnecessary jargon hinders efficient communication
rather than helping it

39. Economics as a Foreign Language
ALL economics and economists use jargon to
some extent
MOST of economics is common sense
Except for a very few non-intuitive ideas,
learning economics amounts to learning how
to express what you know in the right jargon,
i.e. it is like learning a new language

40. The Economic Way of Thinking
Margins and Incentives
People make choices at the margin, which means that
they evaluate the consequences of making small
incremental changes in the use of their resources.
The benefit from pursuing an incremental increase in an
activity is its marginal benefit.
The cost of pursuing an incremental increase in an activity
is its marginal cost.
These are both best thought of as rates – how much
benefit or cost for a one-unit change.

41. The Economic Way of Thinking
Margins and Incentives
Marginal benefit and marginal cost act as incentives —
inducements to take a particular action or not.
For any activity, if marginal benefit exceeds marginal cost,
people have an incentive to do more of that activity
If marginal cost exceeds marginal benefit, people have an
incentive to do less of that activity.
Economists seek to predict choices by looking at changes
in incentives, that is, in marginal cost and benefit.

42. Economics: A Social Science
Social Science
Economics is a social science.
Economists distinguish between two types of statements:
▪What is — positive statements
▪What ought to be — normative statements
A positive statement can be tested by checking it against
facts – if it is false, data will show it to be false.
A normative statement cannot be tested – it involves
opinion or value judgments.

43. Economics: A Social Science
Model Building
An economic model is a description of some aspect of
the economic world that includes only those features of
the world that are needed for the purpose at hand.

44. Economics: A Social Science
Obstacles and Pitfalls in Economics
Economists cannot easily do experiments and most
economic behavior has many simultaneous causes.
To isolate the effect of interest, economists use the logical
device called ceteris paribus or “other things being equal”
Economists try to isolate cause-and-effect relationships by
changing only one variable at a time, holding all other
relevant factors unchanged.

45. Economics: A Social Science
Obstacles and Pitfalls in Economics
Three common fallacies that economists try to avoid are:
1. The fallacy of composition, which is the false statement that
what is true for the parts is true for the whole or what is true for
the whole is true for the parts.
2. The post hoc fallacy from the Latin term “post hoc, ergo
propter hoc”—means “after this, therefore because of this,”
which is the error of reasoning that a first event causes a
second event because the first occurs before the second. The
Rooster crowing does not make the sun rise.

46. Economics: A Social Science
3. The cum hoc fallacy from the Latin term “cum hoc, ergo propter
hoc”—means “with this, therefore because of this,” which is the
error of reasoning that correlation proves causation.
Examples of the cum hoc fallacy
Example 1:
The faster windmills are observed to rotate, the more wind is observed to be.
Therefore wind is caused by the rotation of windmills.
Example 2:
Sleeping with one's shoes on is strongly correlated with waking up with a
headache. Therefore, sleeping with one's shoes on causes headache.