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Chapter 1
What is Economics?
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In this lecture, I will explain:
What is Economics all about?
What are the two major branches of economics?
What are the key principles of economics that definean economic way of thinking?
What are the basic tools of analysis in economics?
What is the usefulness of studying economics?
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Definition of Economics
All economic questions arise because we want more thanwe can get.
Wants are unlimited and resources are limited.
Our inability to satisfy all our wants is called scarcity .
Everyone in the world faces scarcity.
Because we face scarcity, we must make c h o i c e s .
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Definition of Economics
Unlimited Wants and Limited Resources Scarcity EconomicProblem Need to study economics
Economics is a social science that studies how individuals,businesses, governments, and entire societies cope with
scarcity and make best possible choices/decisions given theresources constraints that they face.
Why study choices?
Choices that individuals, businesses and the entire societymake in order to allocate their limited resources, determine theireconomic future and their economic well-being.
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Definition of Economics
How do economic agents make choices?
The choices we make depend on the incentives we face.
An incentive is a reward that encourages an action or apenalty that discourages an action
The choices that these agents make depends uponincentives that they face.
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Definition of Economics
Economics is divided into two main parts: Microeconomics
Macroeconomics
Microeconomics is the study of choices thatindividuals and businesses make, the way thosechoices interact in markets, and the influence ofgovernments.
Macroeconomics is the study of the performance of thenational and global economies.
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The Economic Way of Thinking
Choices and Tradeoffs
Scarcity requires choices and choices involvetradeoffs.
Every choice involves a tradeoff giving up onething to get something else.
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The Economic Way of Thinking
Opportunity Cost
Thinking about a choice as a tradeoff emphasizes cost asan opportunity forgone.
The highest-valued alternative that we give up to getsomething is the opportunity cost of the activity chosen.
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The Economic Way of Thinking
Every action involved in making a choice has costs andbenefits associated with it.
When people make choices, economists assume that they
engage in rational behavior which means that theycarefully weigh the costs and benefits of each action withthe goal of maximizing their net economic benefit. Try tomake the best or a better, rational choice. The pointwhere this goal is achieved is called the optimal point.
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The Economic Way of Thinking
Choosing at the Margin
People make choices at the margin , which means thatthey evaluate the consequences of making incrementalchanges in the use of their resources.
The benefit from pursuing an incremental increase in anactivity is its marginal benefit .
The opportunity cost of pursuing an incremental increasein an activity is its marginal cost .
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The Economic Way of Thinking
Responding to Incentives
Our choices respond to incentives.
For any activity, if marginal benefit exceeds marginal cost,people have an incentive to do more of that activity.
If marginal cost exceeds marginal benefit, people have an
incentive to do less of that activity.When marginal benefit is equal to marginal cost, they haveno incentive to either increase or decrease the level of theactivity. The optimal point is reached.
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Two Big Economic Questions
Two big questions summarize the scope of economics:
How do choices end up determining w h a t , h o w , and f o rw h o m goods and services get produced?
When do choices made in the pursuit of se l f - in t e re s t also promote the s o c i a l i n t e r es t ?
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Two Big Economic Questions
What, How, and For Whom?
Goods and services are the objects that people valueand produce to satisfy human wants.
What?
Agriculture accounts for less than 1 percent of totalCanadian production, manufactured goods for 20 percent,
and services for 80 percent.In China, agriculture accounts for 10 percent of totalproduction, manufactured goods for 50 percent, andservices for 40 percent.
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Two Big Economic Questions
Figure 1.1 shows thetrends in what theCanadian economyhas produced over thepast 60 years.
It shows the decline ofagriculture, mining,
construction, andmanufacturing, and theexpansion of services.
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Two Big Economic Questions
The facts about what we produce raise the deeperquestion: What determines the quantities of timber,coal, automobiles, new homes, cable TV service, anddental service that we produce?
Economics provides some answers to these questions.
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Two Big Economic Questions
How?
Goods and services are produced by using productiveresources that economists call factors of production .
Factors of production are grouped into four categoriesdetermined by Adam Smith:
Land
Labour
Capital
Entrepreneurship organized land, lavour, and capital.
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Two Big Economic QuestionsThe gifts of nature that we use to produce goods andservices are land .
The work time and work effort that people devote toproducing goods and services is labour .
The quality of labour depends on human capital , which isthe knowledge and skill that people obtain from education,on-the-job training, and work experience. Embedded inlabour and entrepreneurship.
The tools, instruments, machines, buildings, and otherconstructions that businesses use to produce goods andservices are capital .
The human resource that organizes land, labour, andcapital is entrepreneurship .
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Two Big Economic Questions
Figure 1.2 shows ameasure of the growth ofhuman capital in Canada
over the past fewdecades the percentageof the population that hascompleted different levelsof education.
Economics explains thesetrends.
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Two Big Economic Questions
For Whom?
Who gets the goods and services depends on the incomesthat people earn.
Land earns rent .
Labour earns wages .
Capital earns rental rate (Financial capital earnsinterest ).
Entrepreneurship earns profit .
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The Economic Way of Thinking
W h a t , Ho w , and Fo r W h o m Tradeoffs
The questions what, how, and for whom become sharperwhen we think in terms of tradeoffs.
W h a t Tradeoffs arise when people choose how to spendtheir incomes, when governments choose how to spendtheir tax revenues, and when businesses choose what to
produce.
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The Economic Way of Thinking
H o w Tradeoffs arise when businesses choose amongalternative production technologies.
Fo r W h o m Tradeoffs arise when choices change thedistribution of buying power across individuals.
Government redistribution of income from the rich to thepoor creates the big tradeoff the tradeoff between
equality and efficiency.
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Two Big Economic Questions
When is the Pursuit of Self-Interest in the SocialInterest?
You make choices that are in your self-interest choices
that you think are best for you.Choices that are best for society as a whole are said to bein the social interest .
An outcome is in the social interest if it uses resourcesefficiently and distributes goods and services fairly.
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Two Big Economic Questions
The Big Question
Is it possible that when each one of us makes choices thatare in our self-interest , it also turns out that these choices
are also in the social interest ? Answer: Most of the times, economic agents acting purelyout of their own self interest also promote social interest.
It is not from the benevolence of the butcher, the brewer, or the bakerthat we expect our dinner, but from their regard to their own interest.Adam Smith: The Wealth of Nations.
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Two Big Economic QuestionsSometimes, a conflict/tension may occur between selfinterest and social interest.
Some examples that illustrate tension between self-interest and social interest are
Environmental pollution and global warming
Globalization and outsourcing of production processes
Natural resource depletion
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The Economic Way of Thinking
Human Nature, Incentives, and Institutions
Economists take human nature as given and view peopleas acting in their self-interest.
Self-interested actions are not necessarily selfish actions.But if human nature is given and people pursue self-interest, how can the social interest be served?
Economists answer by emphasizing the role of institutionsin creating incentives that compel individuals to behave inthe social interest.
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The Economic Way of ThinkingWhat are Institutions?
Formal and informal rules and laws that define the incentivestructure in the society and govern the behaviour of individualsand the governments.
Some ways to gauge the quality of institutions:
Political Institutions : Democracy, accountability, human rights,freedoms (religious, economic and political)
Economic Institutions : Enforcement of property rights andcontracts, the conduct of governments monetary and fiscalpolicy
Others : Control of Corruption, Rule of Law and Order
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Economics: Tools of Analysis
Economics as Social Science
Economists distinguish between two types of statement:
How things are (the statement of facts) positive
statements
How things ought to be (involves judgements or is anopinion) normative statements
A positive statement can be tested by checking it againstfacts (statistical data).
A normative statement cannot be tested.
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Economics: Tools of Analysis
Studying relationships between economic variables
The key task of economic science is to understand how theeconomic world works.
Economists study relationships between different economicvariables . Since many economic variables interact witheach other, it is challenging to unscramble the effect of onevariable from the other. To deal with this challenge,economists use economic models.
An economic model is a description of some aspect of theeconomic world that includes only those features that areneeded for the purpose at hand.
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Usefulness of Economics as a PolicyTool
Economics as Policy Tool
Economics is a way of approaching problems in allaspects of our lives. Three broad areas are
Personal economic policy
Business economic policy
Government economic policy
