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Economics and Economic Reasoning

In my vacations, I visited the poorest quarters of severalcities and walked through one street after another, looking

at the faces of the poorest people. Next I resolved to make

as thorough a study as I could of Political Economy .

Alfred Marshall

CHAPTER1

Copyri ght 2010 by the McGraw-Hi ll Companies, Inc. All ri ghts reserved.McGraw-Hill/Irwin

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What Economics Is

Economics is the study of how human beings coordinate their

wants and desires, given the decision-making mechanism,

social customs, and political realities of the society

McGraw-Hill/Irwin

The three central coordination problems any economy

must solve:

1. What, and how much, to produce

2. How to produce it

3. For whom to produce it

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Scarcity

Scarcity exists because individuals want more than can

be produced

McGraw-Hill/Irwin

The degree of scarcity is constantly changing

The quantity of goods, services and usable resources

depends on technology and human action

Scarcity means the goods available are too few

to satisfy individuals desires

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Modern Economics

Economics, like any field of study, evolves and changes

McGraw-Hill/Irwin

Modern economics is based both on deduction and

induction

Abductionis the combination of deduction and induction

Inductionis a method of reasoning in which

one develops general principles by looking forpatterns in the data

Deductionis a method of reasoning in whichone deduces a theory based on a set of almost

self-evident principles

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Marginal costs and marginal benefits

McGraw-Hill/Irwin

Using economic reasoning, decisions are often made by

comparing marginal costs and marginal benefits

Marginal cost is the additional cost over and

above costs already incurred

Marginal benefit is the additional benefit above

and beyond what has already accrued

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The economic decision rule:

McGraw-Hill/Irwin

If the marginal benefits of doing something exceed the

marginal costs, do it.

If the marginal costs of doing something exceed the

marginal benefits, dont do it.

MB > MC Do it!

MC > MBDont do it!

Marginal costs and marginal benefits

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Opportunity Cost

McGraw-Hill/Irwin

Opportunity cost is the basis of cost/benefit economic

reasoning

Opportunity cost should always be less than the benefitof what you have chosen

Opportunity cost is the benefit forgone of the next-best

alternative to the activity you have chosen

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Economic and Market Forces

McGraw-Hill/Irwin

The invisible hand is the price mechanism that guides

our actions in a market. The invisible hand is an example

of a market force.

A market force is an economic force that is given

relatively free rein by society to work through the market

Economic forces are mechanisms that ration scarce goods

If there is a shortage, prices rise

If there is a surplus, prices fall

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Economic and Market Forces

McGraw-Hill/Irwin

Political and social forces often work together against

the invisible hand

Social, cultural, and political forces influence market

forces

What happens in society can be seen as a reaction to,

and interaction of:

Economic forces

Social forces Historical forces

d i

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Economic Insights

McGraw-Hill/Irwin

Theories are too abstract to apply in specific cases and

are often embodied in economic models and principles

Theories tie together economists terminology and

knowledge about economic institutions

An economic principle is a commonly held

insight stated as a law or general assumption

An economic model is a framework that places

the generalized insights of the theory in a more

specific contextual setting

I d i

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Economic Insights

McGraw-Hill/Irwin

Models lead to

theorems (propositions that are logically truebased on the assumptions of the model)

to arrive at policy precepts (policy rules that

conclude that a particular course of action is

preferable)

Theories, models, and principles are continually tested

to see of the predictions of the model match the data

These theorems must be combined with knowledge of

real-world economic institutions and value judgments

to determine economic goals for society

I d i

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The Invisible Hand Theory

McGraw-Hill/Irwin

Prices fallwhen quantity supplied is greater thanquantity demanded

Prices rise when the quantity demanded is greater

than the quantity supplied

According to the invisible hand theory, a market

economy, through the price mechanism, will allocate

resources efficiently

Efficiency means achieving a goal as cheaply as possible

I d i 1

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Economic Institutions

McGraw-Hill/Irwin

Economic institutions are laws, common practices,

and organizations in a society that affect the economy

Economic institutions differ significantly among nations

They sometimes seem to operate differently than

economic theory predicts

To apply economic theory to reality, you've got to have

a sense of economic institutions

I t d ti 1

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Economic Policy Options

McGraw-Hill/Irwin

To distinguish between objective and subjective analysis,

economics is divided into three categories

1. Positive economics is the study of what is

2. Normative economics is the study of what

should be

3. Art of economics is using the knowledgeof positive economics to achieve the goals

determined in normative economics

Objective Policy Analysis