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Chapter 1Chapter 1

The Economic ApproachThe Economic Approach

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OverviewOverview

Basic terms and definitionsBasic terms and definitions Eight guideposts to economic Eight guideposts to economic

thinkingthinking Positive and normative economicsPositive and normative economics Four pitfalls to avoid in economic Four pitfalls to avoid in economic

thinkingthinking

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What is Economics?What is Economics?

Economics is the study of how we Economics is the study of how we make choices under scarcity.make choices under scarcity.

1. Choice1. Choice – The act of selecting – The act of selecting among alternativesamong alternatives

2. Scarcity2. Scarcity – The concept that there – The concept that there is less of a good freely available is less of a good freely available from nature than people would like.from nature than people would like.

ex. time, money, cars, etc. ex. time, money, cars, etc.

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ScarcityScarcity

A. Scarcity is not the same thing as A. Scarcity is not the same thing as povertypoverty

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ScarcityScarcity

B. Scarcity necessitates rationingB. Scarcity necessitates rationing a. a. RationingRationing – Allocating scarce goods – Allocating scarce goods to those who want them.to those who want them.

b. In a market economy, price is used b. In a market economy, price is used to ration goodsto ration goods

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ScarcityScarcity

C. Scarcity leads to competitive C. Scarcity leads to competitive behaviorbehavior

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What do we do in the face of What do we do in the face of scarcity?scarcity?

When will the world run out of oil?When will the world run out of oil?

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ResourcesResources

ResourcesResources: An input used to produce : An input used to produce an economic goodan economic good

1. Human resources (human capital)1. Human resources (human capital)

2. Physical resources (physical capital)2. Physical resources (physical capital)

3. Natural resources3. Natural resources

CapitalCapital: Human-made resources used : Human-made resources used to produce other goods and services.to produce other goods and services.

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Example of Human CapitalExample of Human Capital

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The Economic Way of ThinkingThe Economic Way of Thinking

Things are not always as they appear:Things are not always as they appear:

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

1. Resources are scarce so trade-offs 1. Resources are scarce so trade-offs must be made (No such thing as a free must be made (No such thing as a free lunch).lunch).

Opportunity CostOpportunity Cost: The highest valued : The highest valued

alternative that must be sacrificed alternative that must be sacrificed when choosing an optionwhen choosing an option

ex. An hour of your timeex. An hour of your time ex. how you spend your next $15ex. how you spend your next $15 ex. Airbags vs. AIDS researchex. Airbags vs. AIDS research

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

2. Individuals are rational: they try to get 2. Individuals are rational: they try to get the most from their limited resources.the most from their limited resources.

“ “greatest benefit at least possible cost”greatest benefit at least possible cost”

ex. Beer or liquorex. Beer or liquor

Note: What is rational for one person Note: What is rational for one person may not be rational for everyonemay not be rational for everyone

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

3. Incentives matter: choice is 3. Incentives matter: choice is influenced in a predictable way by influenced in a predictable way by changing incentiveschanging incentives

ex. Money gameex. Money game

ex. Killer seatbelts ex. Killer seatbelts

ex. Pricesex. Prices

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

4. Individuals make decisions at the margin4. Individuals make decisions at the margin MarginalMarginal: Describes the effect of a : Describes the effect of a

change in the current situationchange in the current situation ex. Ponderosa Buffetex. Ponderosa Buffet ex. Supersizing your extra value mealex. Supersizing your extra value meal ex. Drive or Flyex. Drive or Fly

**Cost-benefit analysisCost-benefit analysis: one will undergo : one will undergo an action when the marginal benefits an action when the marginal benefits outweigh the marginal costs*outweigh the marginal costs*

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

5. Information helps us make better 5. Information helps us make better choices, but is costly.choices, but is costly.

ex. New car vs. New pencilex. New car vs. New pencil

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

6. Beware of secondary effects: 6. Beware of secondary effects: economic actions generate both direct economic actions generate both direct and indirect effectsand indirect effects

Secondary effectSecondary effect: the indirect impact : the indirect impact of an event or policy that may not be of an event or policy that may not be easily and immediately observable.easily and immediately observable.ex. Yacht taxex. Yacht tax

ex. Trade restrictionsex. Trade restrictions

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

7. The value of a good or service is subjective: 7. The value of a good or service is subjective:

ex. FSU Football Ticketsex. FSU Football Tickets

ex. How much would you pay for a bottle of ex. How much would you pay for a bottle of water right now?water right now?

Moving goods and services to those who Moving goods and services to those who value them most is a primary source of value them most is a primary source of economic progress. economic progress.

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8 Guideposts to Economic Thinking8 Guideposts to Economic Thinking

8. The test of a theory is its ability to 8. The test of a theory is its ability to predictpredict

If real world events are consistent If real world events are consistent with a theory, then that theory is with a theory, then that theory is validvalid

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Testing TheoriesTesting Theories

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Positive vs. Normative EconomicsPositive vs. Normative Economics

Positive economicsPositive economics: the scientific : the scientific study of what is (testable)study of what is (testable)

Normative economicsNormative economics: Judgments : Judgments

about what ought to be (not testable)about what ought to be (not testable)

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4 pitfalls to avoid in economic 4 pitfalls to avoid in economic thinkingthinking

1. Violation of ceteris paribus principle1. Violation of ceteris paribus principle

ceteris paribusceteris paribus: other things : other things constantconstant

ex. Buying Rosesex. Buying Roses

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4 pitfalls to avoid in economic 4 pitfalls to avoid in economic thinkingthinking

2. The belief that good intentions 2. The belief that good intentions guarantee desirable outcomesguarantee desirable outcomes

ex. Endangered species actex. Endangered species act

ex. Child resistant safety capsex. Child resistant safety caps

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4 Pitfalls to avoid in economic 4 Pitfalls to avoid in economic thinkingthinking

3. The belief that association is 3. The belief that association is causationcausation

ex. Superstitionsex. Superstitions

ex. Initials and performanceex. Initials and performance

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4 Pitfalls to avoid in economic 4 Pitfalls to avoid in economic thinkingthinking

4. Fallacy of composition: belief that 4. Fallacy of composition: belief that what is true for one might be true for what is true for one might be true for allall

ex. Standing at a football gameex. Standing at a football game

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The Economic Way of ThinkingThe Economic Way of Thinking

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Microeconomics vs. Microeconomics vs. MacroeconomicsMacroeconomics

Microeconomics: focuses on how human Microeconomics: focuses on how human behavior affects the conduct of affairs behavior affects the conduct of affairs within individually defined units such as within individually defined units such as households or firms (the trees)households or firms (the trees)

Macroeconomics: focuses on how human Macroeconomics: focuses on how human behavior affects outcomes in highly behavior affects outcomes in highly aggregated markets such as the aggregated markets such as the nations market for labor (the forest).nations market for labor (the forest).

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ReviewReview

1. What is scarcity1. What is scarcity

2. What are the 8 guideposts to 2. What are the 8 guideposts to economic thinkingeconomic thinking

3. Positive vs. Normative economics3. Positive vs. Normative economics

4. What are the 4 pitfalls to avoid in 4. What are the 4 pitfalls to avoid in economic thinking economic thinking