2. When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Define economics, distinguish between micro- economics and macroeconomics, and explain the questions of macroeconomics. 1 Describe the work of economists as social scientists. Explain four core ideas that define the way economists think about macroeconomic questions. Explain why economics is worth studying. 2 3 4

3. 1.1 DEFINITIONS AND QUESTIONS All economic questions and problems arise because human wants exceed the resources available to satisfy them. Scarcity The condition that arises because the available resources are insufficient to satisfy wants. Faced with scarcity, we must make choices—we must choose among the available alternatives. The choices we make depend on the incentives we face.

4. 1.1 DEFINITIONS AND QUESTIONS Incentive An incentive is a reward or a penalty—a “carrot” or a “stick”—that encourages or discourages an action. Economics The social science that studies the choices that we make as we cope with scarcity and the incentives that influence and reconcile our choices. The subject has two broad divisions—microeconomics and macroeconomics.

5. 1.1 DEFINITIONS AND QUESTIONS  Microeconomics Microeconomics : The study of the choices that individuals and businesses make, the way these choices interact, and the influence that governments exert on these choices.  Macroeconomics Macroeconomics : The study of the aggregate (or total) effects on the national economy and the global economy of the choices that individuals, businesses, and governments make.

6. 1.1 DEFINITIONS AND QUESTIONS  Macroeconomic Questions The three big issues that macroeconomics tries to understand are: The standard of living The cost of living Economic fluctuations—recessions and expansions

7. 1.1 DEFINITIONS AND QUESTIONS The Standard of Living Standard of living The level of consumption of goods and services that people enjoy, on the average; it is measured by average income per person. Goods and services The objects that people value and produce to satisfy human wants. Goods are physical objects, and services are work done for people.

8. 1.1 DEFINITIONS AND QUESTIONS For most people achieving a high standard of living means finding a good job. Unemployment The state of being available and willing to work but unable to find suitable work.

9. 1.1 DEFINITIONS AND QUESTIONS The Cost of Living Cost of living The number of dollars it takes to buy the goods and services that achieve a given standard of living. Inflation A situation in which the cost of living is rising and the value of money is shrinking.

10. 1.1 DEFINITIONS AND QUESTIONS Economic Fluctuations: Recessions and Expansions Business cycle A periodic but irregular up-and-down movement in production and jobs. The worst recession ever was the Great Depression. Great Depression A period during the 1930s in which the economy experienced its worst-ever recession.

11. 1.1 DEFINITIONS AND QUESTIONS Figure 1.1 shows a business cycle. An expansion ends at a peak and a recession ends at a trough.

12. 1.2 ECONOMICS: A SOCIAL SCIENCE Goal of economists is to discover how the economic world works. Economists distinguish between: Positive statements: What is Normative statements: What ought to be The task of economic science: To discover and catalog positive statements that are consistent with what we observe in the world and that enable us to understand how the economic world works.

13. 1.2 ECONOMICS: A SOCIAL SCIENCE The task can be broken into three steps: Observing and measuring Model building Testing  Observing and Measuring Items such as: Quantities of resources Wages and work hours Prices and quantities of goods and services Taxes and government spending Volume of international trade

14. 1.2 ECONOMICS: A SOCIAL SCIENCE  Model Building Economic model A description of some aspect of the economic world that includes only those features of the world that are needed for the purpose at hand.

15. 1.2 ECONOMICS: A SOCIAL SCIENCE  Testing A model’s predictions might correspond to or conflict with the data. Economic theory A generalization that summarizes what we understand about the economic choices that people make and the economic performance of industries and nations.

16. 1.2 ECONOMICS: A SOCIAL SCIENCE  Unscrambling Cause and Effect The central idea that economists use to unscramble cause and effect is ceteris paribus. Ceteris Paribus Ceteris paribus means “other things being equal.” But ceteris paribus can be a problem in economics when testing a model.

17. 1.2 ECONOMICS: A SOCIAL SCIENCE Economist take three complimentary approaches: Natural experiments Econometric investigations Economic experiments Natural Experiments A situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal.

18. 1.2 ECONOMICS: A SOCIAL SCIENCE Econometric Investigations Economic investigations use statistical tools. Correlation The tendency for the values of two variables to move in a predictable and related way. Post hoc fallacy The error of reasoning that a first event causes a second event because the first occurred before the second.

19. 1.2 ECONOMICS: A SOCIAL SCIENCE Economic Experiments Economic experiments put real subjects in a decision making situation and vary the influence of interest to discover how the subjects respond to one factor at a time. A relatively new approach.

20. 1.3 MACROECONOMIC IDEAS Four core ideas: Macroeconomic performance results from rational choices that respond to incentives. The standard of living improves when production per person increases. The cost of living rises when the quantity of money increases faster than production. Economic fluctuations result from expenditure and productivity flucutations.

21. 1.3 MACROECONOMIC IDEAS  Rational Choice and Incentives A rational choice is one that uses the available resources to most effectively satisfy the wants of the person making the choice. Cost: What You Must Give Up Opportunity cost The highest-valued alternative forgone.

22. 1.3 MACROECONOMIC IDEAS Benefit: Gain Measured by What You Are Willing to Give Up Benefit The gain or pleasure that something brings. On the Margin Margin A choice that is made by comparing all the relevant alternatives systematically and incrementally.

23. 1.3 MACROECONOMIC IDEAS Marginal cost The cost of a one-unit increase in an activity Marginal benefit What you gain when you get one more unit of something. We make a rational choice when we take those actions for which marginal benefit exceeds or equals marginal cost.

24. 1.3 MACROECONOMIC IDEAS  The Standard of Living and Productivity The dollar value of production increases for three reasons: Prices and wages rise The number of people employed increases Productivity increases Productivity Total production per person employed. Only an increase in productivity brings an improvement in the standard of living.

25. 1.3 MACROECONOMIC IDEAS  The Cost of Living and the Quantity of Money A rising cost of living, called inflation, means that more dollars are needed to buy the same fixed quantity of goods and services. Inflation is caused by an increase in the quantity of money that is not matched by an increase in the quantity of goods and services.

26. 1.3 MACROECONOMIC IDEAS  Expenditure and Productivity Fluctuations The business cycle is the least well understood aspect of macroeconomic performance. The sources of economic fluctuations can be grouped into: Expenditure fluctuations Productivity fluctuations

27. 1.3 MACROECONOMIC IDEAS Expenditure Fluctuations Expenditure fluctuations can arise from changes in interest rates or from changes in profit opportunities. Productivity Fluctuations Productivity fluctuations can arise from negative shocks such as an oil price hike or from positive events like the spread of information-age technologies.

28. 1.3 MACROECONOMIC IDEAS Smoothing the Business Cycle Economic fluctuations are undesirable: recession brings unemployment and overly strong expansion brings inflation. Macroeconomics tries to develop techniques for smoothing the business cycle.

29. Two main benefits from studying economics are: Understanding Expanded career opportunities  Understanding Economic ideas is all around you. You cannot ignore them. As you progress with you study of economics, you’ll gain a deeper understanding of what is going on around you. 1.4 WHY ECONOMICS IS WORTH STUDYING

30.  Expanded Career Opportunities Most students of economics don’t become economists. But knowledge of economics is vital is many fields such as banking, finance, business, management, insurance, real estate, law, government, journalism, health care and the arts. Economics graduates are not the highest-paid professional, but they are close to the top. 1.4 WHY ECONOMICS IS WORTH STUDYING

31. Graduates in disciplines that teach problem identifying, problem solving, and strategic brokering are top of the earnings distribution: engineering computer science economics Figure 1.1 shows some earnings comparisons. 1.4 WHY ECONOMICS IS WORTH STUDYING

32.  The Costs of Studying Economics The main cost of studying economics is forgone leisure time. Most students find that economics is difficult and that it takes time to master. The trick is practice, or learning by doing.  Benefits Versus Costs Weigh up your benefits and costs! 1.4 WHY ECONOMICS IS WORTH STUDYING

34.  When you have completed your study of this appendix, you will be able to A P P E N D I X C H E C K L I S T Interpret a scatter diagram, a time-series graph, and a cross- section graph. 1 Interpret the graphs used in economic models. Define and calculate slope. Graph relationships among more than two variables. 2 3 4

35.  Basic Idea A graph enables us to visualize the relationship between two variables. To make a graph, set two lines perpendicular to each other: The horizontal line is called the x-axis. The vertical line is called the y-axis. The common zero point is called the origin. APPENDIX: MAKING AND USING GRAPHS

36. Figure A1.1 How to make a graph The horizontal axis (x-axis) measures income. The vertical axis (y- axis) measures expenditure.

37. APPENDIX: MAKING AND USING GRAPHS Point A shows that when income is $10,000, expenditure is also $10,000. Point B shows that when income is $30,000, expenditure is $25,000.

38. APPENDIX: MAKING AND USING GRAPHS  Interpreting Data Graphs Scatter diagram A graph of the value of one variable against the value of another variable. Time-series graph A graph that measures time on the x-axis and the variable or variables in which we are interested on the y-axis.

39. APPENDIX: MAKING AND USING GRAPHS Trend A general tendency for the value of a variable to rise or fall. Cross-section graph A graph that shows the values of an economic variable for different groups in a population at a point in time.

40. APPENDIX: MAKING AND USING GRAPHS Figure A1.2(a) shows a scatter diagram. The data for the 1990s show that as income increases, expenditure also increases. In 1996 (marked 96), income per person was $21,100 and expenditure per person was $20,100.

41. APPENDIX: MAKING AND USING GRAPHS Figure A1.2(b) shows another scatter diagram. The data show that as the price falls, the number of calls increases. In 1993 (marked 93) when the price of an international phone call was $1.24 a minute, 11.4 billion minutes of calls were made.

42. APPENDIX: MAKING AND USING GRAPHS Figure A1.2(c) shows a times series graph of the unemployment rate. The graph shows when the unemployment rate was: High and low, Rising and falling, Rising quickly and slowly and falling quickly and slowly.

43. APPENDIX: MAKING AND USING GRAPHS Figure A1.2(d) shows a cross-section graph. The graph shows the unemployment rate in seven countries in 2002.

44. APPENDIX: MAKING AND USING GRAPHS  Interpreting Graphs Used in Economic Positive relationship or direct relationship A relationship between two variables that move in the same direction. Linear relationship A relationship that graphs as a straight line.

45. APPENDIX: MAKING AND USING GRAPHS Figure A1.3(a) shows a positive (direct) relationship. As the speed increases, the distance traveled in 5 hours increases proportionately. At a speed of 40 MPH, you travel 200 miles in 5 hours— point A. At a speed of 60 MPH, you travel 300 miles in 5 hours— point B.

46. APPENDIX: MAKING AND USING GRAPHS Figure A1.3(b) shows a positive (direct) relationship. As the distance sprinted increases, recovery time increases. But sprint twice as far and it takes more than twice as long to recover—the curve gets steeper.

47. APPENDIX: MAKING AND USING GRAPHS Figure A1.3(c) shows a positive (direct) relationship. As study time increases, the number of problems worked increases. But study twice as long and the number of problems you work less than double—the curve gets less steep.

48. APPENDIX: MAKING AND USING GRAPHS Negative relationship or inverse relationship A relationship between two variables that move in opposite directions.

49. APPENDIX: MAKING AND USING GRAPHS Figure A1.4(a) shows a negative (inverse) relationship. As the time playing tennis increases, the time playing squash decreases. Because one more hour of tennis means one hour less of squash, the relationship between these two variables is described by a straight line.

50. APPENDIX: MAKING AND USING GRAPHS Figure A1.4(b) shows a negative (inverse) relationship. As the journey length increases, the cost per mile of the trip falls. But there is a limit to how much the cost per mile can fall, so the curve becomes less steep as journey length increases.

51. APPENDIX: MAKING AND USING GRAPHS Figure A1.4(c) shows a negative (inverse) relationship. As leisure time increases, the number of problems worked decreases. But the tenth hour of leisure (the first hour of work) decreases the number of problems worked most, so the curve becomes steeper as leisure time increases.

52. APPENDIX: MAKING AND USING GRAPHS Figure A1.5(a) shows a maximum point. 1. The curve slopes upward as the yield per acre rises. 2. The curve is flat at point A, the maximum yield. 3. Then slopes downward as the yield per acre falls. As the rainfall increases:

53. APPENDIX: MAKING AND USING GRAPHS Figure A1.5(a) shows a minimum point. 1. The curve slopes downward as the cost per mile falls. 2. The curve is flat at point B, the minimum cost per mile. 3. The curve slopes upward as the cost per mile rises. As the speed increases:

54. APPENDIX: MAKING AND USING GRAPHS Figure A1.6(a) shows variables that are unrelated. As the price of bananas increases, the student’s grade in economics remains at 75 percent. The curve is horizontal.

55. APPENDIX: MAKING AND USING GRAPHS Figure A1.6(b) shows variables that are unrelated. As rainfall in California increases, the output of French vineyards remains at 3 billion gallons. The curve is vertical.

56. APPENDIX: MAKING AND USING GRAPHS  The Slope of a Relationship Slope The change in the value of the variable measured on the y-axis divided by the change the value of the variable measured on the x-axis. Slope =  y ÷  x.

57. APPENDIX: MAKING AND USING GRAPHS Figure A1.7(a) shows a positive slope. 1. When ∆x is 4, 2. ∆y is 3. 3. Slope (∆y/∆x) is 3/4.

58. APPENDIX: MAKING AND USING GRAPHS Figure A1.7(b) shows a negative slope. 1. When ∆x is 4, 2. ∆y is –3. 3. Slope (∆y/∆x) is –3/4.

59. APPENDIX: MAKING AND USING GRAPHS Figure A1.7(c) shows the slope of a curve at a point. 1. When ∆x is 4, 2. ∆y is 3. 3. Slope (∆y/∆x) is 3/4. Slope of the curve at A equals the slope of the red line tangent to the curve at A.

60. APPENDIX: MAKING AND USING GRAPHS  Relationships Among More Than Two Variables To graph a relationship that involves more than two variables, we use the ceteris paribus assumption. Ceteris Paribus “other things remaining the same.” Figure A1.8 shows the relationships between ice cream consumed, the temperature, and the price of ice cream.

61. APPENDIX: MAKING AND USING GRAPHS Figure A1.8(a) shows the relationship between price and consumption, temperature remaining the same.

62. APPENDIX: MAKING AND USING GRAPHS Figure A1.8(b) shows the relationship between temperature and consumption, price remaining the same.

63. APPENDIX: MAKING AND USING GRAPHS Figure A1.8(c) shows the relationship between price and temperature, consumption remaining the same.