1 The Art and Science ofThe Art and Science ofEconomic AnalysisEconomic Analysis

What is the economic problem?

What is the “art” of economic analysis?

What is the “science” of economic analysis?

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What Economics Is All About Scarcity refers to the limited nature of society’s

resources.

Economics examines how people use their scarce resources to satisfy their unlimited wants.

• How many hours should a student work or study?

• How do firms decide how many works to hire and what skill levels those workers need?

• How should a local government decide where stoplights are needed?

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Scarce Resources, Unlimited Wants

Resources are the inputs used to produce the goods and services that people want.

• Labor

• Capital

• Natural resources

• Entrepreneurial ability

Because resources are scarce, we must make choices.

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How People Make Decisions

Decision making is at the heart of economics.

Understanding the forces that shape these choices is the first step to mastering the art of economics.

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How People Make Decisions

By rational, economists mean that people try to make the best choices they can, given the available information.

Individuals are assumed to be self-interested.

Rational Self-InterestRational Self-Interest

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"It is not from the benevolence of the butcher, the brewer, or the baker,

that we expect our dinner, but from their regard to their own self-interest.

We address ourselves, not to their humanity but to their self-love, and

never talk to them of our own necessities but of their advantages."

-- Adam Smith, The Wealth of Nations (1776)

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How People Make Decisions

Time and information are scarce and valuable.

Information is costly to acquire.

• How do we decide how much?

Choice Requires Time and InformationChoice Requires Time and Information

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How People Make Decisions

Many decisions are not “all or nothing,” but involve marginal changes – incremental adjustments to an existing plan.

Evaluating the costs and benefits of marginal changes is an important part of decision making.

Economic Analysis is Marginal AnalysisEconomic Analysis is Marginal Analysis

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How People Make Decisions

Examples:

A student considers whether to go to college for an additional year, comparing the fees & foregone wages to the extra income he could earn with an extra year of education.

A firm considers whether to increase output, comparing the cost of the needed labor and materials to the extra revenue.

Economic Analysis is Marginal AnalysisEconomic Analysis is Marginal Analysis

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How People Make Decisions

Rational people respond to incentives because they make decisions by comparing costs and benefits. Examples:

• In response to higher gas prices, sales of “hybrid” cars rise.

• In response to higher potential fines, drivers are less likely to speed in work zones.

Economic Analysis is Marginal AnalysisEconomic Analysis is Marginal Analysis

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : ExerciseExercise

You are selling your 1996 Mustang. You have already spent $1,000 on repairs.

At the last minute, the transmission dies. You can pay $600 to have it repaired or sell the car “as is.”

In each of the following scenarios, should you have the transmission repaired?

A. The blue book value is $6,500 if the transmission works; $5,700 if it doesn’t

B. The blue book value is $6,000 if the transmission works; $5,500 if it doesn’t

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Microeconomics and Macroeconomics

Microeconomics is the study of how households and firms make decisions and how they interact in markets.

Macroeconomics is the study of the economy as a whole

These two branches of economics are closely intertwined, yet distinct: they address different questions.

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The Science of Economic Analysis

Economists employ the scientific method, which is the dispassionate development and testing of theories about how the world works.

This means the economist uses models, which are simplifications of reality so that predictions can be made.

Models incorporate assumptions which may seem unrealistic but allow us to focus on what is important.

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Some Familiar Models

A road map

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Some Familiar Models

A model of human anatomy from high school biology class

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Some Familiar Models

A model airplane

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Some Familiar Models

The model teeth at the dentist’s office

Don’t forget to floss!

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Normative Versus Positive

A positive statement is one that can be proved or disproved by reference to facts.

A normative statement is one that represents an opinion and cannot be proved or disproved.

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AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : Identifying positive vs. normativeIdentifying positive vs. normative

Which of these statements are “positive” and which are “normative”? How can you tell the difference?

a. Prices rise when the government increases the quantity of money.

b. The government should print less money.

c. A tax cut is needed to stimulate the economy.

d. An increase in the price of gasoline will cause an increase in the consumer demand for video rentals.

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Pitfalls to Avoid

The fallacy that association is causation

The fallacy of composition

The mistake of ignoring secondary effects

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AA CC TT II VV E LE L EE AA RR NN II NN G G 44: : A Brain Teaser:A Brain Teaser:

In 1995, the federally-mandated 55-miles-per-hour speed limit was repealed. At that time, the National Highway Traffic Safety Administration predicted that highway deaths would rise by 6,400 per year.

In 1998, the same organization announced that annual traffic deaths declined from 41,817 (in 1995) to 41,480 (in 1996).

How did this happen?

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