1 What Is Economics? Why does public discussion of economic policy so often show the abysmal ignorance of the participants? Whey do I so often want to cry at what public figures, the press, and television commentators say about economic affairs? Robert M. Solow

Contents Ideas for Beyond the Final Exam Inside the Economist’s Toolkit Appendix: Using Graphs: A Review Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Ideas for Beyond the Final Exam Idea 1: How Much Does It Really Cost? Opportunity cost = value of the best forgone alternative to any decision All actions  opportunity costs Opportunity costs  true economic costs

Ideas for Beyond the Final Exam Idea 2: The Market Strikes Back Markets set prices. Government may intervene. Markets may “strike back.” Example: rent control reduces the supply of housing.

Ideas for Beyond the Final Exam Idea 3: The Surprising Principle of Comparative Advantage When two nations trade, both benefit. Comparative advantage = the production of goods with the lowest opportunity cost Comparative advantage  specialization

Ideas for Beyond the Final Exam Idea 4: Trade is a Win-Win Situation Trade  benefits for both buyers & sellers Restrictions on trade   benefits Intervention into markets   costs

Ideas for Beyond the Final Exam Idea 5: The Importance of Thinking at the Margin Marginal = small change Marginal costs = change in costs Rational decisions = comparison of costs to benefits at the margin

Ideas for Beyond the Final Exam Idea 6: Externalities: Shortcoming of the Market Cured by Market Methods Externalities = effects of transactions on third parties Externalities  social costs Market failure  need for government intervention

Ideas for Beyond the Final Exam Idea 7: The Trade-off between Efficiency and Equality More efficiency  more output & jobs More equality  less efficiency Labor markets distribute income efficiently, not equally.

Ideas for Beyond the Final Exam Idea 8: The Short-Run Trade-off between Inflation and Unemployment Low unemployment  rising prices High unemployment  falling prices

Ideas for Beyond the Final Exam Idea 9: Productivity Growth Is (Almost) Everything in the Long Run Productivity growth  more output More output  higher living standards In the long run, productivity growth is (almost) everything.

Inside the Economist’s Toolkit Economics as a Discipline Economics is the most scientific of the social sciences. Yet, it is much more social than the natural sciences.

Inside the Economist’s Toolkit The Need for Abstraction Real world complexity  simplification in economic theory The “art” of economics: focus on the essential; ignore the trivial.

Inside the Economist’s Toolkit The Role of Economic Theory Economic theory = explanation of why economic events occur Correlation  causality Economic theories  predictions

Inside the Economist’s Toolkit What Is an Economic Model? Economic model = formal statement of economic theory Usually expressed in mathematics, with equations and graphs

Inside the Economist’s Toolkit Reasons for Disagreements: Imperfect Information and Value Judgments Among economists, agreement > disagreement Imperfect information  disagreements Value judgments  disagreements

Appendix Using Graphs: A Review

Graphs Used in Economic Analysis Display large quantity of data quickly Facilitate data interpretation and analysis Important statistical relationships more apparent than from written descriptions or long lists of numbers

Two-Variable Diagrams Variable = something measured by a number Examples: price and quantity View two variables together to see if they exhibit a relationship.

TABLE 1-1 Quantities of Natural Gas Demanded at Various Prices Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 1-1 Hypothetical Demand Curve for Gas 6 6 5 5 4 4 Price Price P a Q P a 3 3 b b 2 2 1 1 Q 20 40 60 80 100 120 140 20 40 60 80 100 120 140 Quantity (a) Quantity (b) Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

The Definition and Measurement of Slope Slope = ratio of vertical change to horizontal change Rise/run Measure of steepness of the line

The Definition and Measurement of Slope The slope of a straight line Negative slope = one variable rises while the other variable falls The two variables move in opposite directions. Positive slope = two variables rise and fall together The two variables move in the same direction.

FIGURE 1-2a Negative Slope Y Negative slope X Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 1-2b Positive Slope Y Positive slope X Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

The Definition and Measurement of Slope Zero slope = the variable on the horizontal axis can be any value while the variable on the vertical axis is fixed Horizontal line Infinite slope = the variable on the vertical axis can be any value while the variable on the horizontal axis is fixed Vertical line

FIGURE 1-2c Zero Slope Y Zero slope X Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 1-2d Infinite Slope Y Infinite slope X Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

The Definition and Measurement of Slope The slope of a straight line Slope is constant along a straight line. Slope can be measured between any two points on one axis and the corresponding two points on the other axis.

FIGURE 1-3 How to Measure Slope Y Y 3 — 10 Slope = C 11 B C 9 1 — 10 Slope = B 8 8 A A X X 3 13 3 13 (a) (b) Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

The Definition and Measurement of Slope The slope of a curved line Slope changes from point to point on a curved line. Curved line bowed toward the origin has a negative slope. Variables change in opposite directions. Curved line bowed away from the origin has a positive slope. Variables change in the same direction.

FIGURE 1-4a Negative Slope in Curved Lines Y Negative slope X Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 1-4b Positive Slope in Curved Lines Y Positive slope X Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

The Definition and Measurement of Slope The slope of a curved line A curved can have both a positive and negative slope depending on where on the curve is measured. The slope at a point on a curved-line is measured by a line tangent to that point.

FIGURE 1-4c,d Behavior of Slope in Curved Lines Y Y Negative slope Positive slope Negative slope Positive slope X X Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 1-5 How to Measure Slope at a Point on a Curve Y r 8 D 7 E 6 R t F 5 C 4 G T 3 M 2 1 A B X 1 2 3 4 5 6 7 8 9 10 Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Rays Through the Origin and 45-degree Lines Y-intercept = point at which a line touches the y axis Ray through the origin = straight line graph with a y-intercept of zero

FIGURE 1-6 Rays through the Origin Slope = + 2 5 Slope = + 1 4 B C D 3 A 2 1 – 2 Slope = + K 1 E X 1 2 3 4 5 Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Squeezing 3 Dimensions into 2: Contour Maps Some problems involve more than two variables Economic “contour map” called a production indifference map Shows how variable Z changes as we change either X or Y

FIGURE 1-8 An Economic Contour Map Y Z = 40 80 Z = 30 70 Z = 20 Z = 10 60 50 Yards of Cloth per Day A 40 30 B 20 10 X 10 20 30 40 50 60 70 80 Labor Hours per Day Copyright© 2003 South-Western/Thomson Learning. All rights reserved.