Chapter 1 The Nature of Economics

Introduction Nearly half of the babies born in Hong Kong Hospitals today have mothers who are classified as tourists visiting from the Chinese mainland. How can fundamental principles of economics explain patterns of social behavior such as this? You will explore this question in Chapter One.

Learning Objectives Discuss the difference between microeconomics and macroeconomics Evaluate the role that rational self-interest plays in economic analysis Explain why economics is a science Distinguish between positive and normative economics 3

Chapter Outline The Power of Economic Analysis Defining Economics The Three Basic Economic Questions and Two Opposing Answers The Economic Approach: Systematic Decisions Economics as a Science Positive versus Normative Economics 5

Did You Know That ... Economics is a rapidly growing college major? During the past 10 years, the number of students majoring in economics at U.S. colleges has increased by 40%? Economics majors typically earn more than students who major in management, chemistry, or psychology? 7

The Power of Economic Analysis Incentives Rewards for engaging in a particular activity The nature of self-interested responses to incentives is the starting point for economic analysis

The Power of Economic Analysis (cont'd) The economic way of thinking is a framework to analyze solutions to economic problems How much time to study Choosing which courses to take Whether the U.S. government should encourage or discourage immigration 9

The Power of Economic Analysis (cont'd) The economic way of thinking gives you the power to reach informed conclusions about what is happening in the world Economic analysis helps you make better decisions, and increases your understanding when watching or reading the news on the Web

The Power of Economic Analysis (cont'd) Economic analysis is a way of thinking about all decisions These decisions could be about: Your education, career, or financing your home Your involvement in the business world How you cast your ballot as a voter 10

Defining Economics Economics The study of how people allocate their limited resources to satisfy their unlimited wants The study of how people make choices 11

Defining Economics (cont'd) Resources Things used to produce other things to satisfy people’s wants Wants What people would buy if their incomes were unlimited 12

Defining Economics (cont'd) With limited income (resources), people must make choices to satisfy their wants We never have enough of everything, including time, to satisfy our every desire 13

Defining Economics (cont'd) Individuals, businesses, and nations face alternatives, and choices must be made Economics studies how these choices are made

Microeconomics versus Macroeconomics The study of decision making undertaken by individuals (or households) and by firms Like looking though a microscope to focus on the smaller parts of the economy The effects of changes in gasoline prices A family’s choice of having a baby An individual firm’s decision to advertise 14

Microeconomics versus Macroeconomics (cont'd) The study of the behavior of the economy as a whole Deals with economywide phenomena The national unemployment rate The rate of inflation The yearly output of goods and services in a nation 15

Microeconomics versus Macroeconomics (cont'd) Macroeconomics deals with aggregates, or totals—such as total output in an economy Modern economic theory blends micro and macro concepts

The Three Basic Economic Questions and Two Opposing Answers Economic System The institutional mechanism through which resources are utilized to satisfy human wants 17

The Three Basic Economic Questions and Two Opposing Answers (cont’d) Three economic questions: What and how much will be produced? How will items be produced? For whom will items be produced? 17

The Three Basic Economic Questions and Two Opposing Answers (cont’d) Two opposing answers in the form of economic systems: Centralized command and control (central planning): Authority that makes all economic decisions Price system (market system): Decentralized decision making process in which prices are terms (signals) under which people agree to make exchanges 17

Policy Example: The Federal Government Directs New California Train Tracks Centralized command and control was used to make decisions regarding a high-speed rail project in California. Railway construction began in the least-populated areas, in order to provide service immediately for areas that were considered to be “underserved”. 17

The Three Basic Economic Questions and Two Opposing Answers (cont’d) Economic systems of the world’s nations (e.g., U.S.) are mixed systems that incorporate aspects of both centralized command and control and a decentralized price system 17

International Policy Example: Cuba Experiments with Mixing It Up Cuba is undergoing a transition in which 600,000 former employees of the public sector will now be employed in the private sector. These workers will be paid wages determined by the price system. 17

The Economic Approach: Systematic Decisions Economists assume that individuals act as if motivated by self-interest and respond predictably to opportunities for gain 17

The Economic Approach: Systematic Decisions (cont’d) “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” —Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 16

The Economic Approach: Systematic Decisions (cont’d) Rationality Assumption The assumption that people do not intentionally make decisions that would leave themselves worse off

The Economic Approach: Systematic Decisions (cont’d) Questions Does the fact that some people make apparently irrational choices invalidate the rationality assumption in economics? Can economic models be applied to situations in which behavior is at odds with what we expect from rational people?

Example: Hello, Bank Robber, I’ll Remember You How can the rationality assumption help prevent bank robberies? Some banks now follow a policy of having a teller, guard, or branch manager greet every person entering the bank. A high probability of being recognized and remembered should deter potential bank robbers.

The Economic Approach: Systematic Decisions (cont’d) Responding to incentives Rationality and the use of incentives Positive incentives Negative incentives Making choices Balancing cost and benefits

The Economic Approach: Systematic Decisions (cont’d) Some examples of incentives Responding to positive incentives Schoolchildren getting gold stars, working to have a “better life” for yourself Responding to negative incentives Penalties, punishments, using credit cards to avoid check overdrafts

The Economic Approach: Systematic Decisions (cont’d) Defining self-interest The pursuit of one’s goals, does not always mean increasing one’s wealth Prestige Friendship Love

Example: The Perceived Value of Gifts Often the recipient of the gift places a value on it far less than the market value. Should we substitute gift certificates for physical gifts?

Economics as a Science (cont’d) Economics is a social science that employs the same kinds of methods used in other sciences, such as biology Economics uses models to explain economic phenomena in the real world

Economics as a Science (cont'd) Models or Theories Simplified representations of the real world used as the basis for predictions or explanations Should capture only the essential relationships that are sufficient to analyze a problem Cannot be faulted as unrealistic simply because they do not capture all details of the real world A map is the quintessential model

Economics as a Science (cont'd) Assumptions The set of circumstances in which a model is applicable Every model, or theory, must be based on a set of assumptions

Example: Getting Directions A map is a simplifying model of reality. The degree of simplification varies across maps; some contain more detail than others. Economic models attempt to focus on what is relevant to the problem at hand and omit what is not.

Economics as a Science (cont'd) Ceteris Paribus Assumption [KAY-ter-us PEAR-uh-bus] Nothing changes except the factor or factors being studied. “Other things constant” “Other things equal”

Economics as a Science (cont'd) Economics is an empirical science Real-world data is used to evaluate the usefulness of a model Models are useful if they predict economic phenomena Economic models predict how people react, not how they think

What if economic theories were based on what people say they would do, rather than on what they actually do? Economists seek to predict what people will do when faced with certain incentives When surveyed for a poll, many people will say that tax breaks have no effect on their charitable donations Yet, we find that charitable giving does respond to tax incentives In this instance, an accurate prediction would need to be based on what people actually do

Economics as a Science (cont'd) Behavioral Economics Approach to the study of consumer behavior Emphasizes psychological limitations and complications which may interfere with rational decision making Proponents believe that it is “unrealistic” to assume: Unbounded selfishness Unbounded willpower Unbounded rationality

Economics as a Science (cont'd) Bounded Rationality Hypothesis that people are nearly, not fully, rational They cannot examine every choice available to them They appear to use rules of thumb to sort alternatives

Positive versus Normative Economics Positive Economics Purely descriptive statements or scientific predictions, such as: “If A, then B.” A statement of what is Normative Economics Analysis involving value judgments; relates to whether things are good or bad. A statement of what ought to be

You Are There: Why So Many Firms Are Incorporating Outside the United States In recent years, an increasing number of U.S. family-owned companies or partnerships have chosen to incorporate in other countries. The fact that the U.S. corporate tax rate is the second highest in the world has given firms an incentive to establish their corporate identity outside U.S. borders.

Mothers from mainland China are responding to incentives: Issues & Applications: Why So Many Tourists Have Been Giving Birth in Hong Kong (cont’d) The increase in “tourist births” is consistent with the rationality assumption. Mothers from mainland China are responding to incentives: The quality of care is better in Hong Kong. A child born in Hong Kong receives the benefit of 12 years of publicly provided education and subsidized health care. Mothers who give birth in Hong Kong are exempt from China’s one-child policy.

Issues & Applications: Why So Many Tourists Have Been Giving Birth in Hong Kong (cont’d) How does Hong Kong benefit from providing these benefits for tourist mothers? There has been a decline in the birth rate among Hong Kong residents. Without immigration, the population would begin to decline. By allowing mothers to give birth and then to remain in Hong Kong, the government pursues a policy of rational self-interest.

Summary Discussion of Learning Objectives Microeconomics versus macroeconomics Economics is the study of how individuals make choices to satisfy wants Microeconomics is the study of decision making by individual households and individual firms Macroeconomics is the study of nationwide phenomena, such as inflation and unemployment levels

Summary Discussion of Learning Objectives (cont'd) Self-interest in economic analysis Rational self-interest is the assumption that individuals behave in a reasonable (rational) way in making choices to further their interests

Summary Discussion of Learning Objectives (cont'd) Economics as a science Economists use models, or theories, that are simplified representations of the real world to analyze and make predictions about the real world

Summary Discussion of Learning Objectives (cont'd) The difference between positive and normative economics Positive economics deals with what is, whereas normative economics deals with what ought to be Positive statements are of the “if…then” variety, while normative ask what “should, or could” be

Appendix A: Reading and Working with Graphs Independent Variable A variable whose value is determined independently of, or outside, the equation under study Dependent Variable A variable whose value changes according to changes in the value of one or more independent variable

Appendix A: Direct and Inverse Relationship Direct Relationship A relationship between two variables that is positive, meaning that an increase in one variable is associated with an increase in the other and a decrease in one variable is associated with a decrease in the other Inverse Relationship A relationship between two variables that is negative, meaning that an increase in one variable is associated with a decrease in the other and a decrease in one variable is associated with an increase in the other

Table A-1 Gas Mileage as a Function of Driving Speed

Figure A-1 Direct and Inverse Relationships

Appendix A: Constructing a Graph Number Line A line that can be divided into segments of equal length, each associated with a number y Axis The vertical axis in a graph x Axis The horizontal axis in a graph Origin The intersection of the y axis and the x axis in a graph

Figure A-2 Horizontal Number Line

Figure A-3 Vertical Number Line

Figure A-4 A Set of Coordinate Axes

Table A-2 T-Shirts Purchased

Figure A-5 Graphing the Relationship Between T-Shirts Purchased and Price

Figure A-6 Connecting the Observation Points

Figure A-7 A Positively Sloped Curve

Appendix A: The Slope of a Line (A Linear Curve) The change in the y value divided by the corresponding change in the x value of a curve The “incline” of the curve “Rise” over “run”

Figure A-8 Figuring Positive Slope

Figure A-9 Figuring Negative Slope

Figure A-10 The Slope of a Nonlinear Curve