The Nature of Economics Chapter 1 The Nature of Economics

Introduction Today, the U.S. government is part owner of some major U.S. banks. What greater government control means for decision making about what and how much to produce, how to organize production, and who obtains the items produced? You will learn the answer to this question in this chapter.

Learning Objectives Discuss the difference between microeconomics and macroeconomics Evaluate the role that rational self-interest plays in economic analysis Explain why the study of economics is a science Distinguish between positive and normative economics 3

Chapter Outline The Power of Economic Analysis Defining Economics The Three Basic Economic Questions and Two Opposing Answers The Economic Approach: Systematic Decisions Economics as a Science Positive versus Normative Economics 5

Did You Know That ... Economics is one of the fastest-growing college majors? During the past 10 years, the number of students majoring in economics at U.S. colleges has increased by 40%? Economics majors typically land higher paying jobs than other majors? 7

The Power of Economic Analysis Incentives Rewards for engaging in a particular activity The nature of individuals’ self-interested responses to incentives is the starting point for economic analysis

The Power of Economic Analysis (cont'd) The economic way of thinking is a framework to analyze solutions to economic problems. How much time to study Choosing which courses to take Whether the U.S. government should encourage or discourage immigration 9

The Power of Economic Analysis (cont'd) The economic way of thinking gives you the power—the power to reach informed conclusions about what is happening in the world. Economic analysis helps you make better decisions, and increases your understanding when watching or reading the news on the Web.

The Power of Economic Analysis (cont'd) Economic analysis is a way of thinking about all decisions. Your education, career, financing your home, family Your involvement in the business world, or in politics as a voter 10

Defining Economics Economics The study of how people allocate their limited resources to satisfy their unlimited wants The study of how people make choices 11

Defining Economics (cont'd) Resources Things used to produce other things to satisfy people’s wants Wants What people would buy if their incomes were unlimited 12

Defining Economics (cont'd) With limited income (resources), people must make choices to satisfy their wants. We never have enough of everything, including time, to satisfy our every desire. 13

Defining Economics (cont'd) Individuals, businesses, and nations face alternatives, and choices must be made. Economics studies how these choices are made.

Microeconomics versus Macroeconomics The study of decision making undertaken by individuals (or households) and by firms Like looking though a microscope to focus on the smaller parts of the economy The effects of changes in gasoline prices A family’s choice of having a baby An individual firm’s decision to advertise 14

Microeconomics versus Macroeconomics (cont'd) The study of the behavior of the economy as a whole Deals with economywide phenomena The national unemployment rate The rate of inflation The yearly output of goods and services in a nation 15

Microeconomics versus Macroeconomics (cont'd) Macroeconomics deals with aggregates, or totals—such as total output in an economy. Modern economic theory blends micro and macro concepts.

The Three Basic Economic Questions and Two Opposing Answers Economic System The institutional mechanism through which resources are utilized to satisfy human wants 17

The Three Basic Economic Questions and Two Opposing Answers (cont’d) Three economic questions: What and how much will be produced? How will items be produced? For whom will items be produced? 17

The Three Basic Economic Questions and Two Opposing Answers (cont’d) Two opposing answers in the form of economic systems: Centralized command and control (central planning): Authority that makes all economic decisions Price system (market system): Decentralized decision making process in which prices are terms (signals) under which people agree to make exchanges 17

The Three Basic Economic Questions and Two Opposing Answers (cont’d) Economic systems of the world’s nations (e.g., U.S.) are mixed systems that incorporate aspects of both centralized command and control and a decentralized price system 17

The Economic Approach: Systematic Decisions Economists assume that individuals act as if motivated by self-interest and respond predictably to opportunities for gain. 17

The Economic Approach: Systematic Decisions (cont’d) “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” —Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 16

International Example: Indian Men Living in the United States Become Ineligible Bachelors For Indian men working in the United States, finding a bride back in India has become more difficult. Today an increasing number of Indian women opt for married life in India, where jobs are plentiful, instead of marrying to a man in the United States, where the unemployment rate has exceeded 10 percent.

The Economic Approach: Systematic Decisions (cont’d) Rationality Assumption The assumption that people do not intentionally make decisions that would leave them worse off

The Economic Approach: Systematic Decisions (cont’d) Questions Does the fact that some people make apparently irrational choices invalidate the rationality assumption in economics? Can economic models be applied to situations in which behavior is at odds with what we expect from rational people?

The Economic Approach: Systematic Decisions (cont’d) Responding to incentives Rationality and the use of incentives Positive incentives Negative incentives Making choices Balancing cost and benefits

The Economic Approach: Systematic Decisions (cont’d) Some examples of incentives Responding to positive incentives Schoolchildren getting gold stars, working to have a “better life” for yourself Responding to negative incentives Penalties, punishments, using credit cards to avoid check overdrafts

Policy Example: The Government Gives Everyone an Incentive to Own a Golf Cart The U.S. government and some state governments offer tax credits to people buying electric vehicles, including golf carts. Golf carts sales have soared as many people have found that these tax credits were sufficient to fund more than two-thirds of the price of a qualifying golf cart.

The Economic Approach: Systematic Decisions (cont’d) Defining self-interest The pursuit of one’s goals, does not always mean increasing one’s wealth Prestige Friendship Love

Example: The Perceived Value of Gifts Often the recipient of the gift places a value on it far less than the market value. Should we substitute gift certificates for physical gifts?

Economics as a Science (cont’d) Economics is a social science that employs the same kinds of methods used in other sciences, such as biology. Economics uses models.

Economics as a Science Models or Theories Simplified representations of the real world used as the basis for predictions or explanations Should capture only the essential relationships that are sufficient to analyze a problem Cannot be faulted as unrealistic simply because it does not represent every detail of the real world A map is the quintessential model

Economics as a Science (cont'd) Assumptions The set of circumstances in which a model is applicable Every model, or theory, must be based on a set of assumptions.

Example: Getting Directions A map is a simplifying model of reality. The degree of simplification varies across maps; some contain more detail than others. Economic models attempt to focus on what is relevant to the problem at hand and omit what is not.

Economics as a Science (cont'd) Ceteris Paribus Assumption [KAY-ter-us PEAR-uh-bus] Nothing changes except the factor or factors being studied. “Other things constant” “Other things equal”

Economics as a Science (cont'd) Economics is an empirical science. Real-world data is used to evaluate the usefulness of a model. Models are useful if they predict economic phenomena. Economic models predict how people react, not how they think.

Economics as a Science (cont'd) Behavioral Economics Approach to the study of consumer behavior Emphasizes psychological limitations and complications which may interfere with rational decision making Proponents believe that it is “unrealistic” to assume: Unbounded selfishness Unbounded willpower Unbounded rationality

Economics as a Science (cont'd) Bounded Rationality Hypothesis that people are nearly, not fully, rational They cannot examine every choice available to them They appear to use rules of thumb to sort alternatives

Why Not … try to increase blood donations by offering small payments to donors? To encourage more people to give blood, some governments now provide small payments to blood donors. But some people who have previously donated blood may become less likely to respond to blood drives because they believe the financial payments might make them look “greedy” by selling blood instead of making a sacrifice.

Positive versus Normative Economics Positive Economics Purely descriptive statements or scientific predictions; “If A, then B,” a statement of what is Normative Economics Analysis involving value judgments; relates to whether things are good or bad, a statement of what ought to be

You Are There: A Movie Producer Responds to Incentives Initially, movie producer Ingo Volkammer planned to film the action movie Velocity in North America. Later the Spanish and German governments offered him subsidies to cover much of the firm’s production cost. But still later changes in the euro’s value raised the dollar-denominated cost of filming in Europe, so that Volkammer eventually returned the climactic scenes to North America.

Issues & Applications: In Many U. S Issues & Applications: In Many U.S. Industries, Command and Control Rules In 2008, the U.S. government required a number of U.S. banks to accept taxpayer-funded purchases of ownership shares in those banks. Even though banks, including JPMorgan Chase and Bank of America, have bought back the government’s shares, the government will likely remain a large shareholders at Citigroup and some other major banks. In 2009 and 2010, government command and control also spread to the auto and health care industries.

Figure 1-1 Banks Receiving the Largest Amounts of U. S Figure 1-1 Banks Receiving the Largest Amounts of U.S. Government Funding

Summary Discussion of Learning Objectives Microeconomics versus macroeconomics Economics is the study of how individuals make choices to satisfy wants Microeconomics is the study of decision making by individual households and individual firms Macroeconomics is the study of nationwide phenomena, such as inflation and unemployment levels

Summary Discussion of Learning Objectives (cont'd) Self-interest in economic analysis Rational self-interest is the assumption that individuals behave in a reasonable (rational) way in making choices to further their interests

Summary Discussion of Learning Objectives (cont'd) Economics as a science Economists use models, or theories, that are simplified representations of the real world to analyze and make predictions about the real world

Summary Discussion of Learning Objectives (cont'd) The difference between positive and normative economics Positive economics deals with what is, whereas normative economics deals with what ought to be Positive statements are of the “if…then” variety, while normative ask what “should, or could” be

Appendix A: Reading and Working with Graphs Independent Variable A variable whose value is determined independently of, or outside, the equation under study Dependent Variable A variable whose value changes according to changes in the value of one or more independent variable

Appendix A: Direct and Inverse Relationship Direct Relationship A relationship between two variables that is positive, meaning that an increase in one variable is associated with an increase in the other and a decrease in one variable is associated with a decrease in the other Inverse Relationship A relationship between two variables that is negative, meaning that an increase in one variable is associated with a decrease in the other and a decrease in one variable is associated with an increase in the other

Table A-1 Gas Mileage as a Function of Driving Speed

Figure A-1 Direct and Inverse Relationships

Appendix A: Constructing a Graph Number Line A line that can be divided into segments of equal length, each associated with a number y Axis The vertical axis in a graph x Axis The horizontal axis in a graph Origin The intersection of the y axis and the x axis in a graph

Figure A-2 Horizontal Number Line

Figure A-3 Vertical Number Line

Figure A-4 A Set of Coordinate Axes

Table A-2 T-Shirts Purchased

Figure A-5 Graphing the Relationship Between T-Shirts Purchased and Price

Figure A-6 Connecting the Observation Points

Figure A-7 A Positively Sloped Curve

Appendix A: The Slope of a Line (A Linear Curve) The change in the y value divided by the corresponding change in the x value of a curve The “incline” of the curve “Rise” over “run”

Figure A-8 Figuring Positive Slope

Figure A-9 Figuring Negative Slope

Figure A-10 The Slope of a Nonlinear Curve