What is Economics About?

Economics: The Social Science which studies social and individual choices in a condition of scarcity with the objective of maximizing the satisfaction of human wants.

Resources and Wants We have limited resources. We have wants which exceed those resources. This leads to scarcity Scarcity exists when there are insufficient resources to satisfy people’s wants.

Economic Resources Land - Natural Resources Labor - Skills of People Capital - Man made inputs to production. (not money) Entrepreneurship - The organizing resource of production; combines the other resources and accepts risk.

Payment to the Resources Rent (for land) Wages (for labor) Interest (for capital) Profit (for entrepreneurial ability)

Circular Flow of Economic Activity Resource Prices & Income Resource Market Wages, Interest, Rent, & Profit Income $ Factors of Production Households Firms Goods and Services Product Market Revenue $ Consumption $ Product Prices

The Questions of Economics Scarcity requires us to make choices involving: What to produce? How to produce it? For Whom? (how Income is distributed?)

Methods of Social Choice Society makes choices through: Market Forces Governmental Forces Social Forces (custom and tradition)

Economic Choice In Capitalist economies the Market is the major rationing device: Markets ration through the forces of Supply and Demand. If Demand > Supply the Price and rations the shortage.

Economic Choice In Command Economies (centrally planned), the Government make choices which allocate resources and decide: What? How? For Whom?

Economic Choice In Mixed Economies (both market and government combined), the society makes choices which allocate resources through a combination of government intervention and market forces. Government Forces: Government Spending Regulation Taxes Subsidies

Opportunity Costs Opportunity Cost - is the highest valued alternative foregone when choosing between alternatives. When an activity is chosen, the opportunity cost is the benefit expected from the next best alternative given up.

Economic Choice To choose, evaluate tradeoffs--the opportunity cost of a choice is the value of the best alternative you gave up “Wow, I could have had a V8!” BEER!

Rational Self-Interest Individuals rationally select alternatives they perceive to be in their best interests

Rational Choice I will choose to make a choice if MB > MC Incentives change Benefit or Cost! Incentives will cause:

Rational Choice I will choose not to make a choice if MB < MC Incentives change Benefit or Cost! Disincentives will cause:

Incentives Economists believe that incentives work. They believe that people respond to incentives (that they weigh the costs and benefits rationally). If the cost of choices increase, less of that choice will be made. If the benefit of a choice is increased, people will make that choice more.

How Do Economists Think: Utility and Rationality Economists assume that people act rationally Economists assume that people act to maximize their own happiness and minimize their costs. This happiness that economists assume people maximize is called utility. This does not mean people are always greedy - some people get happiness from others happiness.

Types of Economics Microeconomics - Studies the behavior of individual decision units (people and firms). Macroeconomics - Studies the behavior of entire economies as a whole.

Types of Economics Positive Economics - The economics of what is. This is descriptive of fact and theory without opinion. A positive economic statement can be proved or disproved by reference to facts. Normative Economics - The economics of what should be. This is economics where policy issues involve evaluation and the opinion of the economist. A normative economic statement represents an opinion, which cannot be proved or disproved.

ECONOMIC GOALS What are our goals and objectives?

ECONOMIC GOALS ECONOMIC GROWTH FULL EMPLOYMENT ECONOMIC EFFICIENCY PRICE LEVEL STABILITY ECONOMIC FREEDOM EQUITABLE DISTRIBUTION ECONOMIC SECURITY BALANCE OF TRADE

ECONOMIC GOALS ECONOMIC GROWTH FULL EMPLOYMENT ECONOMIC EFFICIENCY TRADEOFFS PRICE LEVEL STABILITY ECONOMIC FREEDOM EQUITABLE DISTRIBUTION ECONOMIC SECURITY BALANCE OF TRADE

Economic Models An economic model is a simplification of reality designed to capture the important elements of the relationship under consideration A model is usually a graph or a set of mathematical equations

How are models created? Inductive Reasoning: Reasoning from facts to generalizations. - Gather, systematically arrange, and draw conclusions from the analysis of facts and data (empirical analysis). Test the theory (hypothesis) against real-world situations. Deductive Reasoning: - Starting with generalities of how the world works, generate hypotheses and test those predictions against real-world situations.

What is the Scientific Method? Problem identification Model development Testing a theory

Either Can Lead to Policies THEORETICAL ECONOMICS THEORIES INDUCTION DEDUCTION FACTS

Scientific Reasoning Issues In complicated, real-world systems, how do you unscramble cause and effect? Hold other things equal (ceteris paribus). Fallacy of composition Post hoc Fallacy If A happens before B, did A cause B? Confusing correlation with causation

Scientific Reasoning Tool Ceteris Paribus: It is Latin for “all else equal” and it means that we are assuming that all other variables which might be related are held constant.

Scientific Reasoning Fallacies: The Fallacy of Composition: What is true for one individual is not always true for the whole group. What is true at the Micro level is not always true at the Macro level. Example: If I stand up at a basketball game, I can see better. If everybody stands up, we can not see any better.

Scientific Reasoning Fallacies Post hoc, ergo propter hoc (after this, therefore because of this). Just because one thing occurs before another does not mean that it caused it. Example: The sun comes up and people drive to work. Did the sunlight cause this activity? Don’t they drive to work on cloudy days?

Scientific Reasoning Fallacies: Correlation vs. Causation : Because two variables are systematically related, (they may increase together or always seem to move in opposite direction) this correlation is not proof of a cause-effect relationship between them. Example: Change in the Money Supply and change in GDP, which causes which?

Graphs Used in Economic Models Patterns to Watch For: variables that move in the same direction variables that move in opposite directions variables that are unrelated 14 16

A Line with Positive Slope x y change in x change in y >0

Two-Variable Diagram Representing a Direct Relationship Income

A Line with Negative Slope x y change in x change in y < 0

Two-Variable Diagram Representing an Inverse Relationship Q P

Two Diagrams Representing Independence between Two Variables

Calculating the Slope of a Line

Calculating Slopes

Calculating the Slope of a Curve at a Particular Point

Graphing Relationships Among More Than Two Variables Price Ice cream consumption (cents per scoop) (gallons per day) 30ºF 50ºF 70ºF 90ºF 15 12 18 25 50 30 10 12 18 37 45 7 10 13 27 60 5 7 10 20 75 3 5 7 14 90 2 3 5 10 105 1 2 3 6 15 29

Functional Relationships DIC = f (P T) Ice Cream demand depends on price and temperature. If temperature increases Demand Increases

A Change in Demand Ceteris paribus, if temperature rises, people will buy more Ice Cream at each price 1 2 3 4 5 6 Price New Demand for Ice Cream Demand for Ice Cream Quantity Ice Cream 1 2 3 4 5 6 7

A Movement Along a Curve vs. A Shift in the Curve Price A change in quantity demanded P0 P2 Q2 D0 Q0 Quantity

A Change in the Quantity Demanded Versus a Change in Demand Price A change in quantity demanded P1 P0 D0 Q1 Q0 Quantity

A Change in the Quantity Demanded Versus a Change in Demand Price A change in demand Decrease in Increase in demand demand D1 D0 D2 Quantity

Key Terms and Concepts Scarcity Economics Utility Land Labor Capital Entrepreneurship Opportunity Cost Marginal Analysis Rational Behavior Induction Deduction Fallacy of Composition Ceteris Paribus Positive Economics Normative Economics Microeconomics Macroeconomics Inverse Relationship Direct Relationship Slope of a line