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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Scope andMethod of Economics

Appendix: How to Read and Understand Graphs

Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

2 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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The Study of Economics

• Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.

3 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Why Study Economics?

• An important reason for studying economics is to learn a way of thinking.

• Three fundamental concepts:

• Opportunity cost

• Marginalism, and

• Efficient markets

4 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Opportunity Cost

• Opportunity cost is the best alternative that we forgo, or give up, when we make a choice or a decision.

• Nearly all decisions involve trade-offs.

5 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Marginalism

• In weighing the costs and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision.

6 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Marginalism

• For example, when a firm decides whether to produce additional output, it considers only the additional (or marginal cost), not the sunk cost.

• Sunk costs are costs that cannot be avoided, regardless of what is done in the future, because they have already been incurred.

7 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Efficient Markets

• An efficient market is one in which profit opportunities are eliminated almost instantaneously.

• There is no free lunch! Profit opportunities are rare because, at any one time, there are many people searching for them.

8 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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More Reasons to Study Economics

• The study of economics is an essential part of the study of society.

• Economic decisions often have enormous consequences.

• During the Industrial Revolution, new manufacturing technologies and improved transportation gave rise to the modern factory system.

9 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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More Reasons to Study Economics

• An understanding of economics is essential to an understanding of global affairs.

• Voting decisions also require a basic understanding of economics.

10 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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The Scope of Economics

• Microeconomics is the branch of economics that examines the behavior of individual decision-making units—that is, business firms and households.

11 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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The Scope of Economics

• Macroeconomics is the branch of economics that examines the behavior of economic aggregates— income, output, employment, and so on—on a national scale.

12 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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The Scope of Economics

Examples of microeconomic and macroeconomic concernsProduction Prices Income Employment

Microeconomics Production/Output in Individual Industries and Businesses How much steelHow many officesHow many cars

Price of Individual Goods and Services Price of medical carePrice of gasolineFood pricesApartment rents

Distribution of Income and Wealth Wages in the auto industryMinimum wagesExecutive salariesPoverty

Employment by Individual Businesses & IndustriesJobs in the steel industryNumber of employees in a firm

Macroeconomics National Production/Output Total Industrial OutputGross Domestic ProductGrowth of Output

Aggregate Price Level Consumer pricesProducer PricesRate of Inflation

National IncomeTotal wages and salaries  

Total corporate profits

Employment and Unemployment in the Economy Total number of jobsUnemployment rate

13 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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The Method of Economics

• Positive economics studies economic behavior without making judgments. It describes what exists and how it works.

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The Method of Economics

• Normative economics, also called policy economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action.

15 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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The Method of Economics

• Positive economics includes:

• Descriptive economics, which involves the compilation of data that describe phenomena and facts.

• Economic theory, which involves building models of behavior.

• An economic theory is a general statement of cause and effect, action and reaction.

16 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Theories and Models

• Theories involve models, and models involve variables.

• A model is a formal statement of a theory. Models are descriptions of the relationship between two or more variables.

17 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Theories and Models

• Ockham’s razor is the principle that irrelevant detail should be cut away. Models are simplifications, not complications, of reality.

18 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Theories and Models

• A variable is a measure that can change from observation to observation.

• The ceteris paribus device is part of the process of abstraction.

• Using the ceteris paribus, or all else equal, assumption, economists study the relationship between two variables while the values of other variables remain constant.

19 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Theories and Models

• Pitfalls to avoid in formulating economic theory:

• The post hoc, ergo propter hoc fallacy refers to a common error made in thinking about causation: If event A happened before event B, it is not necessarily true that A caused B.

• The fallacy of composition is the erroneous belief that what is true for a part is also true for the whole.

20 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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The Method of Economics

• Empirical economics refers to the collection and use of data to test economic theories.

• Many data sets are available to facilitate economic research. They are collected by both government agencies and private companies,

21 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Economic Policy

Criteria for judging economic outcomes:

• Efficiency, or allocative efficiency. An efficient economy is one that produces what people want at the least possible cost.

• Equity, or fairness of economic outcomes.

22 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Economic Policy

Criteria for judging economic outcomes:

• Economic growth, or an increase in the total output of an economy.

• Economic stability, or the condition in which output is steady or growing, with low inflation and full employment of resources.

23 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Review Terms and Concepts

ceteris paribusceteris paribus

descriptive economicsdescriptive economics

economic growth

economic theory

economics

efficiency

efficient market

empirical economics

equity

fallacy of composition

Industrial RevolutionIndustrial Revolution

macroeconomics

microeconomics

model

normative economics

ockham’s razor

opportunity cost

positive economics

post hoc, ergo propter hoc

stability

sunk costs

variable

24 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Appendix:How to Read and Understand Graphs

• A graph is a two-dimensional representation of a set of numbers or data.

25 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Appendix:How to Read and Understand Graphs

• A time series graph shows how a single variable changes over time.

Total Disposable Personal Income in the United States: 1975-2002 (in billions of dollars)

100015002000250030003500400045005000550060006500700075008000

1975 1980 1985 1990 1995 2000

Year

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Appendix:How to Read and Understand Graphs

• The Cartesian coordinate system is the most common method of showing the relationship between two variables.

• The horizontal line is the X-axis and the vertical line the Y-axis. The point at which the horizontal and vertical axes intersect is called the origin.

27 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Appendix:How to Read and Understand Graphs

• The point at which the The point at which the line intersects the Y-line intersects the Y-axis (point axis (point aa) is called ) is called the the Y-intercept.Y-intercept.

• TheThe Y-intercept Y-intercept, is the , is the value of value of YY when when XX = 0. = 0.

28 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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• The The slopeslope of the line of the line indicates whether the indicates whether the relationship between relationship between the variables is positive the variables is positive or negative.or negative.

• The slope of the line is The slope of the line is computed as follows:computed as follows:

b =Y

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29 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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Appendix:How to Read and Understand Graphs

• This line slopes upward, indicating that there seems to be a positive relationship between income and spending.

• Points A and B, above the 45° line, show that consumption can be greater than income.

30 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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A A downward-slopingdownward-sloping line describes a line describes a negative relationshipnegative relationship between X and Y.between X and Y.

An An upward-slopingupward-sloping line describes a line describes a positive relationshippositive relationship between X andbetween X and Y.Y.

31 of 33© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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b 5

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Cartesian coordinate systemCartesian coordinate system

graphgraph

negative relationshipnegative relationship

originorigin

positive relationshippositive relationship

slopeslope

time series graphtime series graph

X-axisX-axis

Y-axisY-axis

Y-interceptY-intercept