1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economics and Economic Reasoning Chapter 1

2. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 2 Laugher Curve u Q. Why did God create economists? u A. In order to make weather forecasters look good.

3. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 3 What Economics Is u Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society.

4. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 4 What Economics Is u One of the key words in the above definition is “coordination.”

5. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 5 What Economics Is u Three central coordination problems any economic system must solve are: l What, and how much, to produce. l How to produce it. l For whom to produce it.

6. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 6 What Economics Is u Scarcity ensues because individuals want more than can be produced. l Scarcity – the goods available are too few to satisfy individuals’ desires.

7. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 7 What Economics Is u The degree of scarcity is constantly changing. u The quantity of goods, services, and usable resources depends on technology and human action.

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 8 What Economics Is u Economics is the study of how to get people to do things they're not wild about doing and not to do things they are wild about doing.

9. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 9 What Economics Is u The following are the five important things to learn in economics: l Economic reasoning. l Economic terminology. l Economic insights economists have about issues, and theories that lead to those insights.

10. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 10 What Economics Is u The following are the five important things to learn in economics: l Information about economic institutions l Information about the economic policy options facing society today.

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 11 A Guide to Economic Reasoning u Economic reasoning is making decisions by comparing costs and benefits.

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 12 Marginal Costs and Marginal Benefits u The relevant costs and benefits that matter are the expected incremental or additional costs incurred and the expected incremental benefits of a decision.

13. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 13 Marginal Costs and Marginal Benefits u If the marginal costs of doing something exceeds the marginal benefits, don’t do it.

14. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 14 Marginal Costs and Marginal Benefits u In economists’ jargon, marginal refers to additional or incremental. l Think of it as one more.

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 15 Marginal Costs and Marginal Benefits u Marginal cost – the additional cost to you over and above the costs you have already incurred. l This means eliminating sunk costs – costs that have already been incurred and cannot be recovered.

16. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 16 Marginal Costs and Marginal Benefits u Marginal benefit – the additional benefit above and beyond what you’ve already accrued.

17. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 17 Marginal Costs and Marginal Benefits u According to the economics decision rule: l If the relevant benefits of doing something exceed the relevant costs, do it. l If the relevant costs of doing something exceed the relevant benefits, don’t do it.

18. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 18 Economics and Passion u Economic reasoning is based on the premise that everything has a cost.

19. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 19 Economics and Passion u Although economists can be as passionate as the next person, they must squelch this normal human response in order to do their work with objectivity.

20. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 20 Opportunity Cost u Opportunity cost – the basis of cost/benefit economic reasoning; it is a cost of the activity you have chosen measured by the benefit foregone, of the next-best alternative to the activity you have chosen.

21. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 21 Opportunity Cost u In economic reasoning, opportunity cost must be less than the benefit of what you have chosen.

22. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 22 Opportunity Cost u Opportunity costs are not limited to individual decisions but to government decisions as well.

23. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 23 Opportunity Cost u The opportunity cost concept applies to all aspects of life and is fundamental to understanding how society reacts to scarcity.

24. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 24 Economics and Market Forces u When goods are scarce, they must be rationed. l Rationing is a mechanism chosen to determine who gets what.

25. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 25 Economics and Market Forces u One of the important choices that a society must make is to what extent economic forces are allowed free rein.

26. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 26 Economics and Market Forces u A market force is an economic circumstance that is given relatively free rein by society to work through the market. l Market forces ration by changing prices.

27. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 27 Economics and Market Forces u Economic reality is controlled by three forces: l Economic forces (the invisible hand). l Social and cultural forces. l Political and legal forces. l Market forces ration by changing prices.

28. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 28 Economics and Market Forces u Economic forces: l The invisible hand is the price mechanism—the rise and fall of prices— that guides our actions in a market. l When there is a shortage, the price goes up. l When there is a surplus, the price goes down.

29. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 29 Economics and Market Forces u Social and cultural forces, political and legal forces: l Political and social forces often work together against the invisible hand. l What happens in society can be seen as a reaction to, and interaction of, the invisible hand, political and legal forces, and social and cultural forces.

30. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 30 Economic Terminology u Learning economic terminology takes repetition and memorization, hardly a fun things to do.

31. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 31 Economic Terminology u Hundreds of economic terms will be introduced in this book. u You will learn them as we go along.

32. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 32 Economic Insights u General insights into how economies work are often based on economic theory. l Economic theory – generalizations about the workings of an abstract economy.

33. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 33 Economic Insights u Theory ties together economists’ terminology and knowledge about economic institutions and leads to economic insights.

34. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 34 Economic Insights u Because theories are too abstract to apply to specific cases, a theory is often embodied in an economic model or an economic principle. l Economic model – a framework that places the generalized insights of the theory in a more specific contextual setting.

35. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 35 Economic Insights u Because theories are too abstract to apply to specific cases, a theory is often embodied in an economic model or an economic principle. l Economic principle – a commonly held insight stated as a law or general assumption.

36. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 36 Economic Insights u Theories, and the models and principles used to represent them, are abstract but efficient means of conveying information.

37. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 37 Economic Insights u In order to understand the theory you must understand the assumptions underlying the theory.

38. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 38 The Invisible Hand Theory u The invisible hand theory states that markets are efficient in coordinating individuals’ decisions, allocating scarce resources to their best possible use.

39. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 39 The Invisible Hand Theory u This insight is called the invisible hand theory – a market economy through the price mechanism will allocate resources efficiently.

40. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 40 Economic Theory and Stories u Economic theory and its models are a shorthand means of telling a story. If you can’t translate a theory into a story, you don’t understand the theory.

41. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 41 Microeconomics and Macroeconomics u Economic theory is divided into two parts: microeconomics and macroeconomics.

42. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 42 Microeconomics and Macroeconomics u Economic theory is divided into two parts: microeconomics and macroeconomics. l One must simultaneously develop a microfoundation of macro and a macrofoundation of micro.

43. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 43 Microeconomics u Microeconomics is the study of individual choice, and how that choice is influenced by economic forces.

44. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 44 Microeconomics u Microeconomic theory considers economic reasoning from the viewpoint of individuals and firms and builds up from there to an analysis of the entire economy.

45. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 45 Microeconomics u Microeconomics studies such things as: pricing policy of firms, households’ decisions on what to buy, and how markets allocate resources among alternative ends.

46. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 46 Microeconomics u Microeconomics analyses from the parts to the whole.

47. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 47 Macroeconomics u Macroeconomics is the study of inflation, unemployment, business cycles, and economic growth. u Macroeconomics analyzes from the whole to the parts.

48. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 48 Economic Institutions u Corporations, governments, and cultural norms are all economic institutions. They differ significantly among nations. u Economic institutions sometimes seem to operate in ways quite different than economic theory predicts.

49. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 49 Economic Institutions u In applying economic theory to reality, you’ve got to have a sense of economic institutions.

50. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 50 Economic Policy Options u Economic policies are actions (or inactions) taken by government to influence economic actions.

51. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 51 Economic Policy Options u Those who wish to carry out economic policy effectively must understand how institutions might change as a result of the economic policy.

52. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 52 Objective Policy Analysis u Good objective policy analysis keeps the value judgments separate from the analysis. u Subjective policy analysis is that which reflects the analyst’s view of how things should be.

53. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 53 Objective Policy Analysis u In order to make the distinction between objective and subjective analysis clear, economists have divided economics into three categories. l Positive economics l Normative economics l Art of economics

54. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 54 Objective Policy Analysis u Positive economics is the study of what is, and how the economy works. l Examples include: how does the stock market work, what are the consequences of rent control on the market for housing, and are the costs of having children related to family income?

55. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 55 Objective Policy Analysis u Normative economics is the study of what the goals of the economy should be. l The word "should" is a dead giveaway to a normative statement.

56. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 56 Objective Policy Analysis u Normative economics is the study of what the goals of the economy should be. l Examples include: people on welfare should work in order to get benefits, inherited wealth should be taxed more heavily, and corporations should not be allowed to move their facilities overseas unless it is agreed to by labor unions.

57. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 57 Objective Policy Analysis u Art of economics is the application of the knowledge learned in positive economics to the achievement of the goals determined in normative economics.

58. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 58 Objective Policy Analysis u Maintaining objectivity is easier in positive economics – harder in normative economics.

59. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 59 Objective Policy Analysis u It is hardest to maintain objectivity in the art of economics since it embodies the problems of both positive and normative economics.

60. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 60 Objective Policy Analysis u One of the best ways to find out about feasible economic policy options is to compare them from one country to another.

61. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1 - 61 Policy and Social and Political Forces u The choice of policy options depends on more than economic theory. u As soon as economists apply economy theory to policy, political and social forces must be taken into account.

62. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economics and Economic Reasoning End of Chapter 1