1. © 2003 McGraw-Hill Ryerson Limited. Economics and Economic Reasoning Chapter 1

2. © 2003 McGraw-Hill Ryerson Limited 1 - 2 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.

3. © 2003 McGraw-Hill Ryerson Limited 1 - 3 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.

4. © 2003 McGraw-Hill Ryerson Limited 1 - 4 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. l Wants are unlimited, but resources are limited

5. © 2003 McGraw-Hill Ryerson Limited 1 - 5 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.

6. © 2003 McGraw-Hill Ryerson Limited 1 - 6 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.

7. © 2003 McGraw-Hill Ryerson Limited 1 - 7 What Economics Is u The following are the five important things to learn in economics (cont’d): l Information about economic institutions l Information about the economic policy options facing society today.

8. © 2003 McGraw-Hill Ryerson Limited 1 - 8 A Guide to Economic Reasoning u Economic reasoning is making decisions by comparing costs and benefits.

9. © 2003 McGraw-Hill Ryerson Limited 1 - 9 Marginal Costs and Marginal Benefits u The relevant costs and benefits to economic reasoning are the expected incremental or additional costs incurred and the expected incremental or additional benefits of a decision.

10. © 2003 McGraw-Hill Ryerson Limited 1 - 10 Marginal Costs and Marginal Benefits u In economists’ jargon, marginal refers to additional or incremental. l Think of it as one more.

11. © 2003 McGraw-Hill Ryerson Limited 1 - 11 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.

12. © 2003 McGraw-Hill Ryerson Limited 1 - 12 Marginal Costs and Marginal Benefits u Marginal benefit = the additional benefit above and beyond what you’ve already accrued.

13. © 2003 McGraw-Hill Ryerson Limited 1 - 13 Marginal Costs and Marginal Benefits u According to the economics decision rule: l If the marginal benefits of doing something exceed the marginal costs, do it. l If the marginal costs of doing something exceed the marginal benefits, don’t do it.

14. © 2003 McGraw-Hill Ryerson Limited 1 - 14 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.

15. © 2003 McGraw-Hill Ryerson Limited 1 - 15 Opportunity Cost u In economic reasoning, opportunity cost must be less than the benefit of the choice you have made.

16. © 2003 McGraw-Hill Ryerson Limited 1 - 16 Opportunity Cost u Opportunity costs are not limited to individual decisions but to government decisions as well.

17. © 2003 McGraw-Hill Ryerson Limited 1 - 17 Opportunity Cost u The opportunity cost concept applies to all aspects of life and is fundamental to understanding how society reacts to scarcity.

18. © 2003 McGraw-Hill Ryerson Limited 1 - 18 Economics and Market Forces u When goods are scarce, they must be rationed. l Rationing is a mechanism chosen to determine who gets what.

19. © 2003 McGraw-Hill Ryerson Limited 1 - 19 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.

20. © 2003 McGraw-Hill Ryerson Limited 1 - 20 Economic Insights u Theory ties together economists’ terminology and knowledge about economic institutions and leads to economic insights.

21. © 2003 McGraw-Hill Ryerson Limited 1 - 21 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.

22. © 2003 McGraw-Hill Ryerson Limited 1 - 22 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.

23. © 2003 McGraw-Hill Ryerson Limited 1 - 23 Economic Insights u Theories, and the models and principles used to represent them, are abstract but efficient, means of conveying information.

24. © 2003 McGraw-Hill Ryerson Limited 1 - 24 Economic Insights u In order to understand the theory you must understand the assumptions underlying the theory.

25. © 2003 McGraw-Hill Ryerson Limited 1 - 25 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.

26. © 2003 McGraw-Hill Ryerson Limited 1 - 26 The Invisible Hand Theory u This insight is called the invisible hand theory – a market economy through the price mechanism will allocate resources efficiently.

27. © 2003 McGraw-Hill Ryerson Limited 1 - 27 Microeconomics and Macroeconomics u Economic theory is divided into two parts: microeconomics and macroeconomics.

28. © 2003 McGraw-Hill Ryerson Limited 1 - 28 Microeconomics u Microeconomics is the study of individual choice, and how that choice is influenced by economic forces.

29. © 2003 McGraw-Hill Ryerson Limited 1 - 29 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.

30. © 2003 McGraw-Hill Ryerson Limited 1 - 30 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.

31. © 2003 McGraw-Hill Ryerson Limited 1 - 31 Microeconomics u Microeconomics analyses from the parts to the whole.

32. © 2003 McGraw-Hill Ryerson Limited 1 - 32 Macroeconomics u Macroeconomics is the study of inflation, unemployment, business cycles, and economic growth. u Macroeconomics analyzes from the whole to the parts.

33. © 2003 McGraw-Hill Ryerson Limited 1 - 33 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.

34. © 2003 McGraw-Hill Ryerson Limited 1 - 34 Economic Institutions u In applying economic theory to reality, you must know about economic institutions.

35. © 2003 McGraw-Hill Ryerson Limited 1 - 35 Economic Policy Options u Economic policies are actions taken by government to influence economic actions.

36. © 2003 McGraw-Hill Ryerson Limited 1 - 36 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.

37. © 2003 McGraw-Hill Ryerson Limited 1 - 37 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.

38. © 2003 McGraw-Hill Ryerson Limited 1 - 38 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

39. © 2003 McGraw-Hill Ryerson Limited 1 - 39 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?

40. © 2003 McGraw-Hill Ryerson Limited 1 - 40 Objective Policy Analysis u Normative economics is the study of what the goals of the economy should be.

41. © 2003 McGraw-Hill Ryerson Limited 1 - 41 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.

42. © 2003 McGraw-Hill Ryerson Limited 1 - 42 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.

43. © 2003 McGraw-Hill Ryerson Limited 1 - 43 Objective Policy Analysis u Maintaining objectivity is easier in positive economics – harder in normative economics.

44. © 2003 McGraw-Hill Ryerson Limited 1 - 44 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.

45. © 2003 McGraw-Hill Ryerson Limited 1 - 45 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.

46. © 2003 McGraw-Hill Ryerson Limited. Economics and Economic Reasoning End of Chapter 1