The Art and Science of Economic Analysis Chapter 1 The Art and Science of Economic Analysis

The Economic Problem Economics: Study of how society deals with scarce resources Scarcity: An imbalance between our desires for goods and service and our ability to provide those goods and services

Resources Inputs or factors of production used to produce goods and services Goods and services are scarce because resources are scarce Labor Capital Natural resources Entrepreneurial ability

Resources Labor: effort of people Capital: productive input created by people Raw materials: productive input used in its natural state Entrepreneurship: ability to create new products or profitable opportunities

Crossover Human Capital: knowledge and skills acquired by people (labor or capital?)

Payments to Resources Labor earns wages Capital earns interest Raw Materials (e.g. land) earns rent Entrepreneurship earns profit

Economic Decision Makers Households Demand goods and services Supply resources Firms Supply goods and services Demand resources Governments Demand goods and services Supply goods and services Provide rules Rest of the World Demand & Supply goods and services Demand & Supply resources

Markets Market: a set of arrangements to facilitate trade Bring together buyers and sellers Determine price and quantity Product markets Goods and services are bought and sold Resource markets Resources are bought and sold

A Simple Circular-Flow Model Flow of Resources Products Income Revenue Among economic decision makers Interaction Households Firms

Exhibit 1 The simple circular-flow model for households and firms Households - Supply resources to resource market; earn income - Demand goods and services from product market; spend income Firms - Demand resources to produce goods and services; payment for resources - Supply goods and services to product market; earn revenue

Micro vs Macro Microeconomics: study of individual decision making in a market economy Macroeconomics: study of the working of the economy as a whole

Rational Self-Interest Individuals are rational make the best choice given the available information Adam Smith: “individuals pursuing own self-interest are led by an ‘invisible hand’ to achieve an outcome that is in society’s best interest”

Choice Requires Time and Information Time and information – scarce; valuable Rational decision makers Willing to pay for information Improve choices Acquire information: Additional benefit expected exceeds the additional cost

The Science of Economic Analysis Economic theory / model Simplification of economic reality Important elements of the problem Make predictions about the real world Good theory Predict what will happen Explain what has happened

The Scientific Method Identify the question and define relevant variables Specify assumptions Other-things-constant (ceteris paribus) Behavioral assumptions Formulate the hypothesis Key variables relate to each other Test the hypothesis - evidence

Normative Versus Positive Positive economics objective or scientific explanations of the workings of the economy ‘What is’ Normative economics offers prescriptions for the economy based on personal value judgments ‘What should be’

Pitfalls of Faulty Economic Analysis The fallacy that association is causation Event A caused event B - associated in time The fallacy of composition What is true for the individual is true for the group The mistake of ignoring the secondary effects Unintended consequences

Marginal Analysis Look at a particular situation and ask if an individual could be better off if we made a small (marginal) change

Marginal Analysis Expected marginal benefit Expected marginal cost Incremental, additional, extra Rational decision maker: Change the status quo if expected marginal benefit exceeds expected marginal cost