The Scope and Method of Economics

Key Introductory Questions Why study economics? What are opportunity costs and how do they differ from sunk costs? What does it mean to say that there’s “no free lunch?” What’s the difference between positive and normative questions? What are some logical pitfalls that often get in the way of clear thinking about important questions?

To Learn a Way of Thinking Probably the most important reason for studying economics is to learn a way of thinking. A good way to introduce economics is to review three of its most fundamental concepts: opportunity cost, marginalism, and efficient markets. If your study of economics is successful, you will use these concepts every day in making decisions. You will be a: Better problem solver More critical thinker More informed voter More successful person Source: Case & Fair, Principles of Microeconomics

Luck or Skill? While there is no doubt that luck, both good and bad, plays a role in determining the success of firms, we believe that success is often no accident. We believe that we can better understand why firms succeed or fail when we analyze decision making in terms of consistent principles of market economics and strategic action. Besanko, et. al Economics of Strategy (2nd)

Common decision making mistakes you can avoid by studying Economics: Use irrelevant information Ignore relevant information Improperly use relevant information

Key Concepts Cartesian coordinate system and graphs Criteria for evaluating economic results Economic growth c. Equity Efficiency d. Stability Criteria for evaluating economic choices (or making decisions or solving problems) Opportunity cost ‘Marginalism’ and sunk costs Efficient markets

Key Concepts (cont’d) Economics Errors or cautions in logic or reasoning Post hoc Fallacy of composition Ceteris paribus Correlation vs. causality Macroeconomics vs. microeconomics Models, theories, and variables Normative vs. positive economics Negative vs. positive slopes

Define Economics Economics is a social science that studies how people, either individually or collectively, make choices to use scarce resources.

Econ Definition Extended People  consumers, workers, gov’t officials Choices  consumption, production, exchange, policies Scarce  limited Resources  natural (e.g. land, water) capital (man-made bldgs & equip) labor managerial skills financial (i.e. money) time

Branches of Economics Microeconomics: The study of the economic behavior of individual consumers, firms, or markets. Macroeconomics: The study of the economic workings and behavior of national or international economies as a whole.

Accounting Costs Out-of-pocket costs or costs as an accountant would define them. Sometimes referred to as explicit costs.

Opportunity Costs The best alternative that we forgo, or give up, when we make a choice or a decision. These are noncash or implicit costs.

Economic Costs Costs that include both explicit costs and the full opportunity costs (implicit costs) of all inputs.

Sunk Costs Costs that cannot be avoided, regardless of what is done in the future, because they have already been incurred.

Total Fixed Costs Costs that do not depend on the quantity of output produced. These must be paid even if output is zero.

Total variable costs Costs that vary with the level of output.

Total Cost The total economic cost of all the inputs used.

Opportunity Cost Examples of A student skipping Dr. Deiter’s Econ class? Going to college versus entering the work place? An investor waiting a year to sell some property versus selling now? A business firm buys some new machinery?

Thought of the Day “There is no such thing as a ‘free’ lunch.” - Milton Friedman

Evaluating Choices Economists are noted for evaluating choices or alternatives by identifying and quantifying the associated benefits and costs. Economists are also noted for emphasizing marginal (or incremental or additional) benefits and costs in choosing among alternatives.

Marginal Analysis Marginal => additional, incremental changes Often involves analyzing how changes in one variable will change/impact another variable Two components of analysis: Direction of change(s) and Magnitude of change(s)

Marginal Analysis Example #1 Joe lives in Houston and is traveling to Kansas City on business. What is the ‘marginal’ cost to Joe of visiting his grandmother who lives in Des Moines by extending his trip one more day?

Marginal Analysis Example #2 Why does an airline sometimes set aside a few seats to be sold at big discounts through pricline.com or other Web sites?

Marginal Analysis Example #3 Sue has been asked by her boss to attend a business meeting 125 miles away by either renting a car for $50 (fuel costs not included) or by driving a company-owned car. Her boss has asked her to choose the cheapest form of transportation for the company. Identify marginal and sunk costs of driving the company car.

Favorite bumper sticker of most economists? Economists Do It ‘Marginally’

Examples of Marginal Analysis Questions Typically of Interest to Firm Managers (TR = total revenue, TC = total cost) What will happen to: Our TR if we sell 1 more unit of product? Our TC if we sell 1 more unit of product? Our profit if we sell 1 more unit of product? Our production if we hire 1 more unit of labor? Our TC if we hire 1 more unit of labor? Our TR if our main competitor lowers the price of their product by $1?

“Good” Economic Decisions Marginal benefits > marginal costs Examples of marginal benefits:  profit  revenue  cost  safety  risk Marginal costs = opposite of above examples

‘Efficient’ markets (or situations) ‘Efficient’ markets (or situations) implies unequal ‘costs’ or ‘profits’ associated with alternatives are eliminated as people respond to incentives (e.g. profit, risk, time savings, price, money, etc.) Examples: Drive-through lanes at a bank Local gas station making ‘excessive’ profits Business firm producing a product out of two plants

Cautions in analyzing variable relationships Ceteris paribus  hold all relevant explanatory variables EXCEPT one constant e.g. # miles driven depends on price of gasoline, ceteris paribus

Cautions in analyzing variable relationships Post hoc fallacy  falsely assuming a first event caused second event e.g. price of gasoline decrease caused the stock market to decrease

Cautions in analyzing variable relationships Correlation does not imply causality e.g. the number of cars and number of crimes in cities are positively correlated; thus, cars cause crimes

Cautions in analyzing variable relationships Fallacy of composition  what is good for one is not necessarily good for all e.g. one person vs. everybody standing up to get a better view at a sporting event

Econ vs Other Social Sciences “Economics is the most quantitative of the social sciences.” Karl Case & Ray Fair Prin. Of Microeconomics, 7th ed.

“All things at first appear difficult.” Chinese Proverb “All things at first appear difficult.”

Types of “Variable” Relationships Direction of Δ Magnitude of Δ Positive Linear or nonlinear (↑ing, ↓ing) Negative Linear or nonlinear (↑ing, ↓ing)

Equation of a straight line where: y = vertical axis variable x = horizontal axis variable Y = b + mx where b = vertical-axis intercept (value of y when x = 0) m = slope = Δy/Δx = Δ = the Greek letter delta meaning “change in”

The slope (m) of a line has two components: Sign > 0  y and x  (or ) together  positive correlation Number (or magnitude) which shows amount y is expected to change for each 1 unit change in x

‘Slope’ and Marginal Analysis The ‘marginal’ or incremental change in Y as a result of a 1 unit change in X is given by the ‘slope’ at that point of the line or curve connecting paired observations of Y and X. e.g. ΔY/ΔX = +6/+3 = +2/+1 = +1/+.5 A +1 unit ΔX results in a +2 unit ΔY or => a +1 unit ΔY results in a +.5 unit ΔX Note: the ‘ratio’ of the changes is 2 to 1

Given any 2 points, one can calculate the actual equation of a straight line: Step #1) Step #2)

Straight line equation calculation (example) Y X 60 4 40 6 M = b = Y1 – MX1 = 60 – (-10)4 = 60 + 40 = 100  Y = 100 – 10X