Macro Chapter 1 The Economic Approach

4 Learning Goals Identify and list the critical components of economics. List and provide examples of the eight guideposts of economic thinking. Distinguish between two types of economic statements Avoid making four common mistakes

Do you think Americans are better off today than they were 100 years ago? How would you determine or measure this? What’s the criteria? Watch Video: Stossel Macro 01-Is life getting worse?

Some criteria to consider: 1900-1920 2007-2011 Life expectancy (years) 47 78 Infant mortality (deaths per 1,000 live births) 100 6.7 Real Per capita GDP $4,800 $46,350 High school completion (percent of adults) 22 90 Electrification (percent of US households) 8 99

Here’s someone who thinks we’re much better off today Watch Video: Louis CK- technology

What Is Economics About?

Economics tries to explain and predict the behavior of consumers, firms, and government.

John M. Keynes: “Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.”

Steven Levitt & Stephen Dubner Super Freakonomics The economic approach isn’t meant to describe the world as any one of us might want it to be, or fear that it is, or pray that it becomes- but rather to explain what it actually is. Most of us want to fix or change the world in some fashion. But to change the world, you first have to understand it.

Steven Levitt & Stephen Dubner Super Freakonomics In his Nobel address, [Gary] Becker suggested that the economic approach is not a subject matter, nor is it a mathematical means of explaining “the economy.” Rather it is a decision to examine the world a bit differently. It is a systematic means of describing how people make decisions and how they change their minds; how they choose someone to love and marry, someone perhaps to hate and even kill; whether, coming upon a pile of money, they will steal from it, leave it alone, or even add to it; why they may fear one thing and yearn for something only slightly different; why they’ll punish one sort of behavior while rewarding a similar one.”

Optional Video: RSAnimate-Freakonomics

Alfred Marshall: Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.

What does the term “scarcity” or “scarce” mean to you? Can we eliminate scarcity? If we can’t, what must we do?

Scarcity and Tradeoffs Scarcity leads to tradeoffs which result in making choices

Scarcity and Tradeoffs Thomas Sowell: “We cannot opt out of economic issues and decisions. Our only options are to be informed, uninformed, or misinformed, when making our choices.”

Historically, mechanisms that have been used to deal with the problem of scarcity: Force Tradition (emphasized past ways, relied on families) Authority (government and church) Market Combinations of 1-4

Scarcity and Tradeoffs Scarcity requires that some wants remain unfulfilled Issues of equity, justice, and fairness are embedded with scarcity

Class Perspective We will focus on the market process of dealing with scarcity. At times we will compare and contrast with the government or collectivist process. Do not confuse the market process as being the same as politically conservative.

The Economic Way of Thinking

Milton Friedman: “The only person who can truly persuade you is yourself. You must turn the issues over in your mind at leisure, consider the many arguments, let them simmer, and after a long time turn your preferences into convictions.”

Always have these guidelines in your economic thought process: The text lists 8 guidelines.

(1) There are always tradeoffs. What you give up is your opportunity cost-value of next best alternative Common mistake: opportunity cost is NOT the sum of everything you give up Reading: Robert Frost-The road not taken

(1) There are always tradeoffs. There is no such thing as a free lunch! Optional Video: Milton Friedman- free lunch myth

(2) Individuals choose purposefully Referred to as economizing behavior-try to get the most benefits for the least cost or effort Also known as rational behavior

Alfred Marshall: “It is deliberateness, and not selfishness, that is the characteristic of the modern age.

Steven Levitt & Stephen Dubner Super Freakonomics Human behavior is influenced by a dazzlingly complex set of incentives, social norms, framing references, and the lessons gleaned from past experience- in a word, context. We act as we do because, given the choices and incentives at play in a particular circumstance, it seems most productive to act that way. This is also known as rational behavior, which is what economics is all about.

(3) Incentives matter As the incentive goes up, you will be more likely to do something (or try to), and vice versa The incentive doesn’t have to be money Watch Video: Freakonomics-Incentives for real estate agents Optional Video: RSAnimate-surprising truth about what motivates

(4) Think on the margin, not in total or on average Marginal means additional or incremental Rule to live by: Continue to engage in an activity as long as the expected marginal benefit is greater than the expected marginal cost.

(5) More information leads to better decision-making, but more information is costly to get Refer back to (1) through (4) There are always tradeoffs Individuals choose purposefully Incentives matter Think on the margin

(6) Many choices create a secondary effect The primary effect is often immediate and visible The secondary effect usually comes later and is not as visible

(7) Value is subjective Beauty is in the eyes of the beholder Value is determined by the purchaser

(8) Economic thinking is scientific thinking Economists use data and information generated by people to explain and predict actions

Steven Levitt & Stephen Dubner Super Freakonomics But while there are exceptions to every rule, it’s also good to know the rule. In a complex world where people can be atypical in an infinite number of ways, there is great value in discovering the baseline. And knowing what happens on average is a good place to start. By so doing, we insulate ourselves from the tendency to build our thinking- our daily decisions, our laws, our governance- on exceptions and anomalies rather than on reality.

(8) Economic thinking is scientific thinking Class Activity: Do you believe that students who regularly attend class earn higher grades? How could you prove (or disprove) that? Reading: David Romer- “Do students go to class? Should they?”

Positive and Normative Economics

Reading: Milton Friedman-Essays in Positive Economics The introduction and Section 1 (pages 1 through 3) are relevant; you may skip the rest.

Pitfalls To Avoid in Economic Thinking

Don’t make one of these errors: (1) Violation of ceteris paribus. Ceteris paribus is Latin for “other things constant.” We want to isolate variables so we typically allow only one to change at a time.

Errors: (2) Good intentions do not necessarily result in good outcomes Milton Friedman: “There is nothing that does so much harm as good intentions”

Steven Levitt & Stephen Dubner Super Freakonomics In the United States especially, politics and economics don’t mix well. Politicians have all sorts of reasons to pass all sorts of laws that, as well-meaning as they may be, fail to account for the way real people respond to real-world incentives.

Errors: (3) Association is NOT causation Watch Video: Freakonomics- parenting causation vs correlation

Errors: (4) Fallacy of Composition Assumption: what’s good for the individual is good for the group. Making this assumption is the fallacy.