Chapter 1 – The Nature of Economics 1-1

1-2 Chapter Outline The Power of Economic Analysis Defining Economics Microeconomics versus Macroeconomics The Economic Person: Rational Self-Interest Economics as a Science Positive versus Normative Economics

1-3 Did You Know That... Six of seven main U.S. railroad lines meet in Chicago? The bottlenecks these lines caused created incentives to lay more track? Incentives are the underpinnings for all the decisions you and others make?

1-4 The Power of Economic Analysis Incentives  Rewards for engaging in a particular activity  These are what you get for making a certain choice

1-5 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 troops should be sent abroad The Power of Economic Analysis (cont'd)

1-6 The Power of Economic Analysis (cont'd) The economic way of thinking gives you the power—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.

1-7 The Power of Economic Analysis (cont'd) Economic analysis is a way of thinking about all decisions.  Your education, career, financing your home, family  Your involvement in the business world, or in politics as a voter

1-8 Defining Economics Economics  The study of how people allocate their limited resources to satisfy their unlimited wants  The study of how people make choices

1-9 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

1-10 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.

1-11 Defining Economics (cont'd) Individuals, businesses, and nations face alternatives, and choices must be made. Economics studies how these choices are made.

1-12 Microeconomics versus Macroeconomics Microeconomics  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  Decision of a worker to work overtime or not  A family’s choice of having a baby  An individual firm advertising

1-13 Microeconomics versus Macroeconomics (cont'd) Macroeconomics  The study of the behavior of the economy as a whole  Deals with economywide phenomena  The national unemployment rate  The rate of growth in the money supply  The national government’s budget deficit

1-14 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.

1-15 The Economic Person: Rational Self-Interest Economists assume that individuals act as if motivated by self-interest and respond predictably to opportunities for gain.

1-16 The Economic Person: Rational Self-Interest (cont'd) “It is not from the benevolence (true goodness) 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

1-17 The Economic Person: Rational Self-Interest (cont'd) Rationality Assumption  The assumption that people do not intentionally make decisions that would leave them worse off

1-18 Example: “Neuroeconomics” Explores the Rationality Assumption Economists want to know which parts of the brain play the greatest role in determining an individual’s choices. Brain scans reveal considerable coordination between the limbic system (governing emotions) and the prefrontal cortex (associated with reason and calculation). There is evidence the brain attempts to factor in reasoned calculations aimed at making a choice consistent with the “best” overall outcome.

1-19 The Economic Person: Rational Self-Interest (cont'd) Responding to incentives  Rationality and the use of incentives  Positive incentives  Negative incentives  Making choices  Balancing cost and benefits

1-20 The Economic Person: Rational Self-Interest (cont'd) Some examples of incentives  Responding to positive incentives  Schoolchildren getting gold stars, getting $$$ for A’s, working to have a “better life” for yourself  Responding to negative incentives  Penalties, punishments, being grounded for an F, using credit cards to avoid check overdrafts

1-21 E-Commerce Example: Playing the Float with Plastic Instead of Checks Checks used to take up to several days to clear. People would rush to make deposits to avoid overdraft charges. Technological developments enhanced digital imaging, and banks have reduced check float. This has provided incentives for more credit card purchases—as they allow for deferred payment. How might high interest rates influence incentives to use credit cards?

1-22 The Economic Person: Rational Self-Interest (cont'd) Defining self-interest  The pursuit of one’s goals, does not always mean increasing one’s wealth…  Prestige  Friendship  Love

1-23 Example: The Perceived Value of Gifts The perceived value of gifts  Often, the recipient of the gift places a value on it far less than the market value. (Think of a crappy gift you got over the holidays…how much did that sweater cost?)  Should we substitute gift certificates for physical gifts?

1-24 Economics as a Science Models or Theories  Simplified representations of the real world used as the basis for predictions or explanations  A map is the quintessential model

1-25 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.  What happens when you assume???

1-26 Economics as a Science (cont'd) Ceteris Paribus Assumption [KAY-ter-us PEAR-uh-bus]  Nothing changes except the factor or factors being studied.  “All other things constant”  For example, it can be predicted that if the price of beef decreases — ceteris paribus — the quantity of beef demanded by buyers will increase.  Ignores known and unknown factors (mad-cow disease, societal shift towards vegetarianism, substitutes like pork or lamb)

1-27 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.

1-28 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

1-29 Economics as a Science (cont'd) Bounded Rationality  Hypothesis that people are nearly, not fully, rational  They cannot examine every choice available to them  Use simple rules of thumb to sort alternatives

1-30 Positive versus Normative Economics Positive Economics  Purely descriptive statements or scientific predictions; “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