2 Objectives After studying this chapter, you will be able to: Define economics and distinguish between microeconomics and macroeconomicsExplain the three big questions of microeconomicsExplain the three big questions of macroeconomicsExplain the ideas that define the economic way of thinkingExplain how economists go about their work as social scientists
3 Choice, Change, Challenge, and Opportunity Economics, the science of choice, has much to say about the change, challenge, and opportunity that we face today.Technological change, terrorism, and recession provide a landscape that is rich with problems to be tackled and choices to be understood.Your economics course helps you to understand the powerful forces that shape and change our world.
4 Definition of Economics ScarcityAll economic questions arise because we are unable to satisfy all our wants—because we face scarcity.Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity.No definition of economics can adequately capture the subject. For that reason, some teachers don’t like definitions and skip right over them. If you are one of these teachers, go ahead. Not much is lost.Other teachers regard a basic definition as essential, and the textbook takes this view. The definition in the text,“…the social science that studies the choices that individuals, businesses, and governments, and entire societies make as they cope with scarcity,” is a modern language version of Lionel Robbins’s famous definition, “Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.”Some teachers like to play with definitions a bit more elaborately. If you are one of these, here are four more, all of which add some useful insight and the last one a bit of fun:John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.”Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being.”Jacob Viner: “Economics is what economists do.”Jim Duesenberry: “Economics is all about how people make choices. Sociology is about why there isn’t any choice to be made.”
5 Definition of Economics MicroeconomicsMicroeconomics is the study of choices made by individuals and businesses, and the influence of government on those choices.MacroeconomicsMacroeconomics is the study of the effects on the national and global economy of the choices that individuals, businesses, and governments make.
6 Three Big Microeconomic Questions Microeconomics seeks to understand what determines:What goods and services are producedHow goods and services are producedFor whom goods and services are producedGoods and services are the objects that people value and produce to satisfy wants.Don’t skip the questions in a rush to get to the economic way of thinking. Open your students’ eyes to economic in the world around them. Ask them to bring a newspaper to class and to identify headlines that deal with stories about What, How, and For Whom. Use Economics in the News Today on your Parkin Web site for a current news item and for an archive of past items (with questions). Pose questions and be sure that the students appreciate that they will have a much better handle on questions like these when they’ve completed their economics course.
7 Three Big Microeconomic Questions What Goods and Services are Produced?Figure 1.1 shows the major items produced in the U.S. economy today.It emphasizes the dominant place of services in our economy.
8 Three Big Microeconomic Questions Figure 1.2 shows the trends in what the U.S. economy has produced over the past 60 years.It shows the decline of agriculture, mining, construction, and manufacturing, and the expansion of services.
9 Three Big Microeconomic Questions The facts about what we produce raise the deeper question: What determines the quantities of realtor services, new homes, DVD players, and corn that we produce?Microeconomics provides some answers to these questions.
10 Three Big Microeconomic Questions How are Goods and Services Produced?Factors of production are the resources that businesses use to produce goods and services.They are grouped into four categories:LandLaborCapitalEntrepreneurship
11 Three Big Microeconomic Questions The “gifts of nature” that we use to produce goods and services are land.The work time and effort that people devote to producing goods and services is labor.The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, on-the-job training, and work experience.
12 Three Big Microeconomic Questions The tools, instruments, machines, buildings, and other constructions that are used to produce goods and services are capital.The human resource that organizes land, labor, and capital is entrepreneurship.
13 Three Big Microeconomic Questions Figure 1.3 shows a measure of the growth of human capital in the United States over the last century—the percentage of the population that has completed different levels of education.
14 Three Big Microeconomic Questions The facts about how we produce raise the deeper question: What determines the quantities of capital, labor, and other resources that get used to produce goods and services?Microeconomics provides some answers to this question.
15 Three Big Microeconomic Questions For Whom are Goods and Services Produced?Who gets the goods and services depends on the incomes that people earn.Land earns rent.Labor earns wages.Capital earns interest.Entrepreneurship earns profit.
16 Three Big Microeconomic Questions Figure 1.4 shows the distribution of income in the United States.The richest 20 percent earn almost 50 percent of total income while the poorest 20 percent earn only 4 percent of total income.
17 Three Big Microeconomic Questions The facts about for whom raise the deeper question:What determines earnings and the distribution of income that in turn determine who gets the goods and services produced?Microeconomics provides some answers to this question.
18 Three Big Macroeconomic Questions Macroeconomics focuses on three big questions:What determines the standard of living?What determines the cost of living?Why does our economy fluctuate?Ask the students to identify headlines that deal with stories about the standard of living, cost of living, and business cycle. Again, your Parkin Web site has a current macro news item and an archive of past news (with questions).With both the micro and macro questions, try to grab the student’s attention and raise a sense of excitement about learning this subject. Again, pose questions and be sure that the students appreciate that they will gain real insights into questions like these when they’ve completed their course.
19 Three Big Macroeconomic Questions What Determines the Standard of Living?The standard of living is the level of consumption that people enjoy on the average and is measured by average income per person.
20 Three Big Macroeconomic Questions Figure 1.5 shows income per person per day in a number of countries and regions.The United States has one of the highest standards of living, and the nations of Africa have the lowest.
21 Three Big Macroeconomic Questions Macroeconomics seeks to explain differences in the standard of living across countries.Macroeconomics also seeks to explain the rate at which the standard of living changes.
22 Three Big Macroeconomic Questions What Determines the Cost of Living?The cost of living is the amount of money it takes to buy the goods and services that a typical family consumes.The cost of living in the United States is the number of dollars it takes to buy the goods and services that a typical family consumes.
23 Three Big Macroeconomic Questions CountryCurrencyPriceU.KPound1.90U.S.Dollar2.50BrazilReal2.95S. AfricaRand9.00ChinaYuan9.90FranceFranc18.50RussiaRuble39.50JapanYen294ChilePeso1,260ItalyLira4,500Table 1.1 shows the price of a Big Mac in ten countries.The number of money units varies a lot, but the cost is similar in each country.What matters is the rate at which prices change.
24 Three Big Macroeconomic Questions A rising cost of living is called inflation.A falling cost of living is called deflation.Inflation brings a shrinking value of the dollar and deflation brings a rising value of the dollar.Macroeconomics seeks to explain the forces that determine the cost of living and the inflation (or deflation) rate.
25 Three Big Macroeconomic Questions Why Does Our Economy Fluctuate?The business cycle is the periodic but irregular up-and-down movement in production and jobs in an economy.During 2001, the U.S. economy entered a mild recession—production and jobs shrank.During the 1990s, the U.S. economy enjoyed a prolonged expansion—production and jobs increased.Figure 1.6 on the next slide illustrates the phases and turning points of a business cycle.
27 Three Big Macroeconomic Questions Why Does Our Economy Fluctuate?Economists remain unsure about the sources of economic fluctuations and about the actions that might be taken to smooth the economy.But in your study of macroeconomics, you will learn what economists have discovered about economic fluctuations.
28 The Economic Way of Thinking Choices and TradeoffsThe economic way of thinking places scarcity and its implication, choice, at center stage.You can think about every choice as a tradeoff—an exchange—giving up one thing to get something else.The classic tradeoff is “guns versus butter.”“Guns” and “butter” stand for any two objects of value.Begin by encouraging the students to use the economic way of thinking to reflect on their own lives.Why are you here in college? Ask the students why they are pursuing a university degree. Most of them will say that they want a high-paying job. Tell them about jobs such as postal workers, long haul truck drivers or grocery clerks that require relatively little training and offer up to $30,000 a year plus benefits. Ask the students to calculate the opportunity cost of being in school. Most students are shaken when they realize that the opportunity cost of a college degree approaches $150,000 to $200,000. Don’t leave them hanging here, though. Mention that a college education does yield a high rate of return and suggest that they study Reading Between the Lines (pp. 46–47) when they get through Chapter 2.
29 The Economic Way of Thinking Microeconomic TradeoffsThe three microeconomic questions become sharper when we think in terms of tradeoffs.“What?” Tradeoffs arise when people choose how to spend their incomes, when governments choose how to spend their tax revenues, and when businesses choose what to produce.Will your tradeoffs improve? You can do your student’s a further favor by helping them to realize that the tradeoffs they face today are as favorable as they will ever be. It’s an old cliché, but effective, to remind them that they are not going to be any more attractive than they are now, nor are they going to gain any additional physical prowess or have any greater capacity to learn than they have at this very moment in their lives. Right now they could do almost anything they set their minds to do. Encourage the students to figure out and be utterly convinced that the benefits they receive from being in college exceed the large opportunity cost that scarcity forces them to bear. Remind them of the relevance of this cost-benefit calculation to their decisions to skip classes, not studying for exams, or retake core courses and delay graduation.Scarcity Versus Poverty Ask the students why they haven’t yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty. You can emphasize this distinction.
30 The Economic Way of Thinking Microeconomic Tradeoffs“How?” Tradeoffs arise when businesses choose among alternative production technologies.“For Whom?” Tradeoffs arise when choices change the distribution of buying power across individuals. Government redistribution of income from the rich to the poor creates the big tradeoff—the tradeoff between equality and efficiency.Who shall live and who shall die? Moving from personal to social decisions, use a “no-win” situation that is of major social importance. Such situations show with stark clarity that scarcity is just as important an issue as poverty. A good example comes from the development of new medical treatments. Every society—even the richest—faces a tradeoff between making new, promising medicines available quickly while assuring that they are also safe. That is why the Food and Drug Administration (FDA) is charged with assessing both the efficacy as well as the safety of each new drug before it is released to the market. Patients who are HIV- positive or who have Alzheimer’s disease or suffer from many types of cancer all require immediate access to the latest, promising medicines in order to have a chance for survival. But without thorough and time-consuming testing procedures, the safety of new drugs is not known. So we must choose between two bad outcomes: 1) lives lost because people take promising drugs that turn out to have unforeseen deadly side-effects, or 2) lives lost because people are denied access to promising drugs until sufficient testing can be performed to check that they are both effective and safe. Regardless of which drug distribution policy we adopt, many people will die. Although depressing, this realty check drives home the deadly seriousness of the phrase, “There is no such thing as a free lunch.”
31 The Economic Way of Thinking Macroeconomic TradeoffsStandard of Living Tradeoffs arise when we choose between current consumption and activities that increase our standard of living.Activities such as saving and investing, education, and research increase future production and consumption possibilities, which increases the standard of living.
32 The Economic Way of Thinking Macroeconomic TradeoffsAn Output-Inflation Tradeoff arises when policymakers choose how much inflation to endure in order to maintain a high level of production.An output-inflation tradeoff arises because a policy action that lowers inflation also lowers output and a policy action that boosts output increases inflation.
33 The Economic Way of Thinking Opportunity CostThinking about a choice as a tradeoff emphasizes cost as an opportunity forgone.The highest-valued alternative that we give up to get something is the opportunity cost of the activity chosen.
34 The Economic Way of Thinking Margins and IncentivesPeople make choices at the margin, which means that they evaluate the consequences of making incremental changes in the use of their resources.The benefit from pursuing an incremental increase in an activity is its marginal benefit.The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.
35 The Economic Way of Thinking Margins and IncentivesMarginal benefit and marginal cost act as an incentive—an inducement to take a particular action.For any activity, if marginal benefit exceeds marginal cost, people have an incentive to do more of that activityIf marginal cost exceeds marginal benefit, people have an incentive to do less of that activity.Economists seek to predict choices by looking at changes in incentives.
36 Economics: A Social Science Economics is a social science.Economists distinguish between two types of statements:What is—positive statementsWhat ought to be—normative statementsA positive statement can be tested by checking it against factsA normative statement cannot be tested.
37 Economics: A Social Science The task of economic science is to discover positive statements that are consistent with what we observe in the world and that enable us to understand how the economic world works.This task is large and breaks into three steps:Observation and measurementModel buildingTesting models
38 Economics: A Social Science Observation and MeasurementEconomists observe and measure economic activity, keeping track of such things as:Quantities of resourcesWages and work hoursPrices and quantities of goods and services producedTaxes and government spendingQuantities of goods and services bought from and sold to other countries
39 Economics: A Social Science Model BuildingAn economic model is a description of some aspect of the economic world that includes only those features of the world that are needed for the purpose at hand.The value of models. Help the students to appreciate the power of models as tools for understanding reality. The analogy of a model as a map is easy and convincing. Jim Peach, a fine economics teacher at the University of New Mexico, gets his students to make paper airplanes on the first day of class. After they fly their paper planes around the classroom (and picking up the debris!) he gets them to talk about what they can learn about real airplanes from experimenting with paper (and other model) planes.
40 Economics: A Social Science Testing ModelsAn economic theory is a generalization that summarizes what we think we understand about the economic choices that people make and the performance of industries and entire economies.A theory is a bridge between a model and reality. It is a proposition about which model works.The success of a model is judged by its ability to predict. Help your student’s appreciate that no matter how appealing or “realistic-looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable. Milton Friedman’s pool hall example illustrates the point nicely. Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving tangents, cosigns and a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It wouldn’t depict what we see—a pool stick striking a pool cue on a rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark, who relies on years of experience and the right “touch.” But constructed correctly, this mathematical model would predict exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can invent analogous examples from any sport.)
41 Economics: A Social Science Obstacles and Pitfalls in EconomicsEconomists cannot easily do experiments and most economic behavior has many simultaneous causes.To isolate the effect of interest, economists use the logical device called ceteris paribus or “other things being equal.Economists try to isolate cause-and-effect relationships by changing only one variable at a time, holding all other relevant factors unchanged.
42 Economics: A Social Science Obstacles and Pitfalls in EconomicsTwo common fallacies that economists try to avoid are:The fallacy of composition, which is the false statement that what is true for the parts is true for the whole or what is true for the whole is true for the parts.The post hoc fallacy from the Latin term “post hoc, ergo propter hoc”—means “after this, therefore because of this,” which is the error of reasoning that a first event causes a second event because the first occurs before the second.
43 Economics: A Social Science Agreement and DisagreementEconomists are often accused of contradicting each other.In contrast to the popular image, economists find much common ground on a wide range of issues.Page 14 of the textbook lists twelve economic propositions that at least 70 percent of all economists polled agreed on.