Chapter 1 The Principles and Practice of Economics

Chapter 1 Outline 1 The Principles and Practice of Economics Key Ideas 1.1 The Scope of Economics 1.2 Three Principles of Economics 1.3 The First Principle of Economics: Optimization 1.4 The Second Principle of Economics: Equilibrium 1.5 The Third Principle of Economics: Empiricism 1.6 Is Economics Good for You? Key Ideas 1. Economics is the study of people’s choices. The first principle of economics is that people try to optimize; they try to choose the best available option. The second principle of economics is that economic systems tend to be in equilibrium, a situation in which nobody would benefit by changing his or her own behavior. The third principle of economics is empiricism—analysis that uses data. Economists use data to test theories and to determine what is causing things to happen in the real world.

1 The Principles and Practice of Economics Evidenced-Based Economics Example: Is Facebook free? $0 but there is no free lunch

1.1 The Scope of Economics Economic Agent = Any group or individual that makes choices, such as consumers, firms, parents, politicians, etc. What does it mean if something is “scarce”?

1.1 The Scope of Economics Economics studies how agents make choices among scarce resources and how those choices affect society. Positive Economics Propositions that can be verified Normative economics Propositions that cannot be verified

1.1 The Scope of Economics Positive Economics Some people took more than one and not everyone got a piece Normative economics Each student should just take one so that everyone gets a piece Point out that normative economics requires a decision-maker that determines what the rules will be and why. You, as the “government” have decided that the fair allocation mechanism is that everyone gets one. But other allocation methods are viable (as discussed earlier) and you need to be able to explain why yours is superior. Or risk losing in the next instructor election!

Microeconomics The study of individuals, firms, government 1.1 The Scope of Economics Microeconomics The study of individuals, firms, government Macroeconomics The study of the whole economy

1.2 Three Principles of Economics Three Principles of Economics: 1. Optimization = making the best choice possible with given information 2. Equilibrium = when everyone is optimizing; no one would be better off with a different choice 3. Empiricism = using data to figure out answers to interesting questions

1.3 The First Principle of Economics: Optimization Opportunity Cost You want to buy a $1,000 computer. If you drive 3 miles, you can buy it for $990. You want to buy a $20 book. If you drive 3 miles, you can buy it for $10. Put this in the context of opportunity cost: if you didn’t make the drive, how much would it cost you if you were in the market for the book? ($10). If you didn’t make the drive, what would it cost you if you were in the market for a computer? ($10). The value of what you gave up is the same.

Costs Benefits 1.3 The First Principle of Economics: Optimization Cost-Benefit Analysis Costs Benefits

1.4 The Second Principle of Economics: Equilibrium Equilibrium A situation in which no one benefits by changing his/her behavior The Free Rider Problem -- Exists when an individual or group is able to enjoy the benefits of a situation without incurring the costs

Which one is experiencing equilibrium? 1.4 The Second Principle of Economics: Equilibrium Which one is experiencing equilibrium?

Is there an incentive for him to change his behavior? 1.4 The Second Principle of Economics: Equilibrium Is there an incentive for him to change his behavior? The free rider is clearly in an equilibrium situation—there is no incentive for him/her to change his or her behavior.

1.4 The Second Principle of Economics: Equilibrium Is this an equilibrium? But the group is not in equilibrium because one of their roommates is not pulling his/her own weight. To eliminate the free rider problem, two things need to occur. First the group needs to decide what is “fair”, and some sort of pressure needs to be brought to bear on the free rider to get him/her to conform—to encourage him/her to conform to a group equilibrium. Markets have no mechanism for deciding what is “fair”. Also the size of the group can change whether a free rider gets away with it. With a small group, it’s easy to see who is not pulling his/her own weight, but in a larger group, that becomes more difficult. But the group is not in equilibrium because one of their roommates is not pulling his/her own weight. To eliminate the free rider problem, two things need to occur. First the group needs to decide what is “fair”, and some sort of pressure needs to be brought to bear on the free rider to get him/her to conform—to encourage him/her to conform to a group equilibrium. Markets have no mechanism for deciding what is “fair”. Also the size of the group can change whether a free rider gets away with it. With a small group, it’s easy to see who is not pulling his/her own weight, but in a larger group, that becomes more difficult.

So if we want to make it cooler, keep people from going to the beach! 1.5 The Third Principle of Economics: Empiricism Crowded beaches and hot temperatures go together. So if we want to make it cooler, keep people from going to the beach! Question: what’s wrong with that conclusion. Point out that sorting out cause and effect is an important part of economics

What are the costs and benefits of this course? Costs 1.6 Is Economics Good for You? What are the costs and benefits of this course? Costs Tuition- only if they are not taking another course Other courses Sleep? Stress?

Costs Tuition Other courses Sleep? Stress? BENEFITS 1.6 Is Economics Good for You? Costs Tuition Other courses Sleep? Stress? BENEFITS Benefit—the major benefit of economics is that they will begin to see the world through “economists’ eyes”.