Economics is NOT about what to think, but HOW to think!
"Economics is not a body of concrete truth, but an engine for the discovery of the truth."
WAY of thinking in a very systematic, rational, logical manner.
In this chapter we will look at the economic way of thinking and we investigate how economists look at making choices and decisions, and see how that is different than a non-economic approach.
"Economic way of thinking is a powerful tool that can help you understand a broad range of real world events."
What is Economics about? About how people make choices.
First principle of economics is that we live in a world of scarcity.
Second principle is that we have unlimited wants and desires.
Third principle - given 1 and 2, we have to make
choices.
Resources - the tools that we can use to battle scarcity.
Three categories of resources:
Through the use of human capital (technology) we have greatly improved our standard of living. Think of life today vs life 200 years ago.
Back to Adam Smith (p. 5), economics is concerned about
how wealth is created.
Economic Way of Thinking
Quote, p. 9 - Keynes.
Economists differ about policy prescriptions - (Hoover wanted a one-armed economist) but there is a common thread of econ theory that is consistent in econ. Most econ principles are just common sense. However, there is nothing common........
Eight Guideposts to Econ Thinking
Econ thinking is based on several key assumption which form the basis of clear econ thinking. Book points out that students who have difficulty with econ have usually failed to grasp the basic principles of econ thinking.
1. The use of scarce resources to produce a good is always costly.
No such thing as a free lunch. Costs may be hidden, or non-monetary, or delayed, but there is always a cost. Econ use opportunity cost as a broad concept of cost, that involves both monetary and non-monetary, implicit and explicit cost. Opportunity cost: the next highest valued alternative that must be sacrificed as a result of choosing an alternative option.
The opportunity cost of coming to class is the value of the next highest-valued opportunity available - sleeping in this morning, going to work, studying for another class, etc.; Simplest case is when we have to choose between A and B (work full time or go to school full time, go to movie A or movie B, vacation to A or B, choose mate A or B, choose job A or B, go to grad school at A or B, stay in school or go into the NBA, etc.). In all these cases the OPP COST of A is ?????, the OPP COST of B is ???????
Common mistakes:
Public education is free.
Toll "free" numbers are "free."
SASE have "free postage."
2. Decision makers choose purposefully; therefore they will economize.
Assumption of rational behavior. We assume people try to maximize their benefits and minimize their cost, Maximize Net Benefits. Firms maximize profits, Individuals maximize UTILITY: general satisfaction, happiness, general well being, etc.
Under what condition may people violate the assumption of rationality?
By acting emotionally, sentimentality, etc.
3. Incentives matter - choice is influenced in a predictable
way by changes in econ incentives.
This may be the BASIC ASSUMPTION OF ALL ECONOMICS.
Tax (penalize) something, you get less of it.
Subsidize (reward) something, you get more of it.
Examples:
1. Cheating on exam - Walt Wms.
2. Humpback houses
3. Houses in Europe
4. Drunk driving example in Norway.
5. Subsidizing home ownership
6. Transporting prisoners
Mistake: Static vs. Dynamic analysis - Tax laws.
4. Economic thinking is marginal (additional) thinking.
Choice always involves changes in the status quo, and these choices result in marginal decisions. A little more or a little less.
Examples:
The marginal cost of producing one more unit.
The marginal cost of one more passenger on a plane.
The marginal benefit/cost of taking one more/less class.
We always make decisions/choices as changes from the current situation, and we analyze marginal costs and marginal benefits of making changes, so that most econ thinking/decisions are marginal.
5. Information is costly, but helps us make better choices.
We take into account the cost of information when making decisions.
Example:
You are going to buy a new car. You want the best car at the best price. There is a cost of search and a benefit of search, and you want to Max benefits and min costs. One cost of search is your time (opp cost). You get Consumer Reports, test drive different cars, talk to your friends, etc. Then you pick a car and try to find the best price. Local dealers, dealers in Detroit, Canada, Florida, etc.....
Information is NOT free.
6. Econ actions generate secondary effects in addition to immediate effects.
We have to be aware of the long-run effects as well as the short-run effects.
Example - tariffs on sugar.
Immediate effect is to increase employment/income in the domestic sugar industry.
Secondary effect is to raise the price of sugar for all consumers, which mean that they have less money to spend on other products. Employment/income declines in the non-sugar industries. Employment/income declines in foreign sugar-producing countries, they have less income to purchase US exports.
Example: law requiring parents to purchase separate
seats on airplanes for small children for increased safety.
Secondary effect: ?
Seat belt laws: more accidents.
CAFE standards for fuel efficiency - secondary cost?
7. Value of a good is subjective/personal.
Preferences differ between individuals. "De Gustibus Non Disputandum."
8. Test of a theory is its ability to predict.
Econ thinking = scientific thinking. Does an econ theory have predictive power? Can it explain the way the real world operates?
Scientific thinking involves:
1. Developing a theory, with certain assumptions
2. Testing the theory empirically, using econometrics for
example.
Problem: economists can't perform controlled experiments
very easily.
Theories have to be consistent with the real world to have
value.
POSITIVE AND NORMATIVE ECONOMICS
Positive economics is an unbiased, objective, scientific approach to issues. An example of positive economics: if the money supply is increased by 10%, interest rates will increase by about 10%, inflation will increase by about 10%, and the dollar will depreciate by about 10% in the currency market.
Normative economics involves a specific policy alternative, because it uses subjective, ethical, or moral judgments in addition to positive approach. Normative economics is about "what ought to be."
Normative economics cannot be tested because they are subjective positions or opinions.
For example:
More land should be set aside for National Parks.
Cigarettes should be classified as drugs and regulated.
Health care should be available to everyone.
Positive economics does not tell us what policy is best,
it just tells us what will happen if a policy is adapted.
PITFALLS TO AVOID IN ECON THINKING
1. Violation of the "ceteris paribus" condition.
Example, we know that if P goes down, Quantity demanded goes up, assuming ceteris paribus. All other things have to be constant - price of other goods, income, tastes, quality, etc. If price goes down, but income also goes down, then we aren't sure what will happen.
Example: smoking research
2. Association is not Causation
In econ theory, we are concerned with causation between econ variables. However, statistical testing really only proves association or correlation, not actually causation.
Example - Theory: Education "causes" higher income.
Higher income may also "cause" higher levels of education.
Bi-directional causality.
Post hoc, ergo propter hoc - after this, therefore because of this.
Example: car wash, men wearing ties make more money.
OUTSTANDING ECONOMIST: Adam Smith (p. 5). Revolutionary approach. Investigated the creation of wealth/standard of living. Defended the free market as the most efficient way to increase the standard of living/ wealth of a society.
INVISIBLE HAND CONCEPT. In pursuing our own self-interest, we are led by an "invisible hand" to benefit society.
Examples:
food in Food Court.
author of the textbook.
inventions - Bill Gates, inventor of washing machine, microwave
oven, fax machine, cellular phone.
Way to make money is to think of other people's problems.....
Appendix: Graphs
p. 22 - inflation
p. 23-24 - direct (pos) and inverse (neg.) relationships
positive vs. negative slope
steep vs. flat.
Critical-Analysis Questions: 1, 2, 4, 7, 9, 10