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

2. 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

3. 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

4. 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

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

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

7. 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

8. 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

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

10. 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

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

12. 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”

13. 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

14. 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

15. 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

16. 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’

17. 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

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

19. 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