1 The Art and Science of Economic Analysis What is the economic problem? What is the “art” of economic analysis? What is the “science” of economic analysis?

What Economics Is All About Scarcity refers to the limited nature of society’s resources. Economics examines how people use their scarce resources to satisfy their unlimited wants. How many hours should a student work or study? How do firms decide how many works to hire and what skill levels those workers need? How should a local government decide where stoplights are needed?

Scarce Resources, Unlimited Wants Resources are the inputs used to produce the goods and services that people want. Labor Capital Natural resources Entrepreneurial ability Because resources are scarce, we must make choices.

How People Make Decisions Decision making is at the heart of economics. Understanding the forces that shape these choices is the first step to mastering the art of economics.

How People Make Decisions Rational Self-Interest By rational, economists mean that people try to make the best choices they can, given the available information. Individuals are assumed to be self-interested.

"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 self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages." -- Adam Smith, The Wealth of Nations (1776) What was true in 1776 is still true today.

How People Make Decisions Choice Requires Time and Information Time and information are scarce and valuable. Information is costly to acquire. How do we decide how much?

How People Make Decisions Economic Analysis is Marginal Analysis Many decisions are not “all or nothing,” but involve marginal changes – incremental adjustments to an existing plan. Evaluating the costs and benefits of marginal changes is an important part of decision making.

How People Make Decisions Economic Analysis is Marginal Analysis Examples: A student considers whether to go to college for an additional year, comparing the fees & foregone wages to the extra income he could earn with an extra year of education. A firm considers whether to increase output, comparing the cost of the needed labor and materials to the extra revenue.

How People Make Decisions Economic Analysis is Marginal Analysis Rational people respond to incentives because they make decisions by comparing costs and benefits. Examples: In response to higher gas prices, sales of “hybrid” cars rise. In response to higher potential fines, drivers are less likely to speed in work zones.

A C T I V E L E A R N I N G 1: Exercise You are selling your 1996 Mustang. You have already spent $1,000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? A. The blue book value is $6,500 if the transmission works; $5,700 if it doesn’t B. The blue book value is $6,000 if the transmission works; $5,500 if it doesn’t 10

Microeconomics and Macroeconomics Microeconomics is the study of how households and firms make decisions and how they interact in markets. Macroeconomics is the study of the economy as a whole These two branches of economics are closely intertwined, yet distinct: they address different questions.

The Science of Economic Analysis Economists employ the scientific method, which is the dispassionate development and testing of theories about how the world works. This means the economist uses models, which are simplifications of reality so that predictions can be made. Models incorporate assumptions which may seem unrealistic but allow us to focus on what is important.

Some Familiar Models A road map

Some Familiar Models A model of human anatomy from high school biology class

Some Familiar Models A model airplane

Some Familiar Models The model teeth at the dentist’s office Don’t forget to floss! The model teeth at the dentist’s office

Normative Versus Positive A positive statement is one that can be proved or disproved by reference to facts. A normative statement is one that represents an opinion and cannot be proved or disproved.

A C T I V E L E A R N I N G 2: Identifying positive vs. normative Which of these statements are “positive” and which are “normative”? How can you tell the difference? a. Prices rise when the government increases the quantity of money. b. The government should print less money. c. A tax cut is needed to stimulate the economy. d. An increase in the price of gasoline will cause an increase in the consumer demand for video rentals. 18

Pitfalls to Avoid The fallacy that association is causation The fallacy of composition The mistake of ignoring secondary effects

A C T I V E L E A R N I N G 4: A Brain Teaser: In 1995, the federally-mandated 55-miles-per-hour speed limit was repealed. At that time, the National Highway Traffic Safety Administration predicted that highway deaths would rise by 6,400 per year. In 1998, the same organization announced that annual traffic deaths declined from 41,817 (in 1995) to 41,480 (in 1996). How did this happen? 20