1 Chapter 1 The Economic Approach

2 Overview Basic terms and definitions Basic terms and definitions Eight guideposts to economic thinking Eight guideposts to economic thinking Positive and normative economics Positive and normative economics Four pitfalls to avoid in economic thinking Four pitfalls to avoid in economic thinking

3 What is Economics? Economics is the study of how we make choices under scarcity. 1. Choice – The act of selecting among alternatives 2. Scarcity – The concept that there is less of a good freely available from nature than people would like. ex. time, money, cars, etc. ex. time, money, cars, etc.

4 Scarcity A. Scarcity is not the same thing as poverty

5 Scarcity B. Scarcity necessitates rationing a. Rationing – Allocating scarce goods a. Rationing – Allocating scarce goods to those who want them. to those who want them. b. In a market economy, price is used b. In a market economy, price is used to ration goods to ration goods

6 Scarcity C. Scarcity leads to competitive behavior

7 What do we do in the face of scarcity? When will the world run out of oil?

8 Resources Resources: An input used to produce an economic good 1. Human resources (human capital) 2. Physical resources (physical capital) 3. Natural resources Capital: Human-made resources used to produce other goods and services.

9 Example of Human Capital

10 The Economic Way of Thinking Things are not always as they appear:

11 8 Guideposts to Economic Thinking 1. Resources are scarce so trade-offs must be made (No such thing as a free lunch). Opportunity Cost: The highest valued alternative that must be sacrificed when choosing an option Opportunity Cost: The highest valued alternative that must be sacrificed when choosing an option ex. An hour of your time ex. An hour of your time ex. how you spend your next $15 ex. how you spend your next $15 ex. Airbags vs. AIDS research ex. Airbags vs. AIDS research

12 8 Guideposts to Economic Thinking 2. Individuals are rational: they try to get the most from their limited resources. “greatest benefit at least possible cost” “greatest benefit at least possible cost” ex. Beer or liquor ex. Beer or liquor Note: What is rational for one person may not be rational for everyone Note: What is rational for one person may not be rational for everyone

13 8 Guideposts to Economic Thinking 3. Incentives matter: choice is influenced in a predictable way by changing incentives ex. Money game ex. Money game ex. Killer seatbelts ex. Killer seatbelts ex. Prices ex. Prices

14 8 Guideposts to Economic Thinking 4. Individuals make decisions at the margin Marginal: Describes the effect of a change in the current situation Marginal: Describes the effect of a change in the current situation ex. Ponderosa Buffet ex. Ponderosa Buffet ex. Supersizing your extra value meal ex. Supersizing your extra value meal ex. Drive or Fly ex. Drive or Fly *Cost-benefit analysis: one will undergo an action when the marginal benefits outweigh the marginal costs*

15 8 Guideposts to Economic Thinking 5. Information helps us make better choices, but is costly. ex. New car vs. New pencil ex. New car vs. New pencil

16 8 Guideposts to Economic Thinking 6. Beware of secondary effects: economic actions generate both direct and indirect effects Secondary effect: the indirect impact of an event or policy that may not be easily and immediately observable. ex. Yacht tax ex. Trade restrictions ex. Trade restrictions

17 8 Guideposts to Economic Thinking 7. The value of a good or service is subjective: ex. FSU Football Tickets ex. How much would you pay for a bottle of water right now? Moving goods and services to those who value them most is a primary source of economic progress. Moving goods and services to those who value them most is a primary source of economic progress.

18 8 Guideposts to Economic Thinking 8. The test of a theory is its ability to predict If real world events are consistent with a theory, then that theory is valid If real world events are consistent with a theory, then that theory is valid

19 Testing Theories

20 Positive vs. Normative Economics Positive economics: the scientific study of what is (testable) Positive economics: the scientific study of what is (testable) Normative economics: Judgments about what ought to be (not testable) Normative economics: Judgments about what ought to be (not testable)

21 4 pitfalls to avoid in economic thinking 1. Violation of ceteris paribus principle ceteris paribus: other things constant ex. Buying Roses ex. Buying Roses

22 4 pitfalls to avoid in economic thinking 2. The belief that good intentions guarantee desirable outcomes ex. Endangered species act ex. Endangered species act ex. Child resistant safety caps ex. Child resistant safety caps

23 4 Pitfalls to avoid in economic thinking 3. The belief that association is causation ex. Superstitions ex. Superstitions ex. Initials and performance ex. Initials and performance

24 4 Pitfalls to avoid in economic thinking 4. Fallacy of composition: belief that what is true for one might be true for all ex. Standing at a football game

25 The Economic Way of Thinking

26 Microeconomics vs. Macroeconomics Microeconomics: focuses on how human behavior affects the conduct of affairs within individually defined units such as households or firms (the trees) Macroeconomics: focuses on how human behavior affects outcomes in highly aggregated markets such as the nations market for labor (the forest).

27 Review 1. What is scarcity 2. What are the 8 guideposts to economic thinking 3. Positive vs. Normative economics 4. What are the 4 pitfalls to avoid in economic thinking