Economics 121 Principles of Macroeconomics Introduction to ...dennisplott.com/uploads/3/1/9/0/31906031/01_uic_econ121_2015su… · Economics 121 Principles of Macroeconomics Introduction

Definition

The Scope ofEconomics

EconomicFundamentals

EconomicMethods

Economic(Logical)Fallacies

EconomicsPolicy

Analytical Tools

Economics 121Principles of Macroeconomics

Introduction to Economics with Extensions

Dennis C. Plott

University of Illinois as ChicagoDepartment of Economicswww.dennisplott.com

Summer 2015

Dennis C. Plott (UIC) Introduction to Economics with Extensions ECON 121 – Summer 2015 1 / 77

www.dennisplott.com

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

What Is Economics?

Ï People make choices as they try to attain their goals. Choices are necessarybecause we live in a world of scarcity.

DefinitionScarcity: A situation in which unlimited wants exceed the limited resourcesavailable to fulfill those wants.Economics: The study of how individuals and societies choose to use the scarceresources that nature and previous generations have provided.

Ï The key word in the definition of economics is choose.Ï Economics is a behavioral, or social, science. In large measure, it is the study of

how people make choices. The choices that people make, when added up,translate into societal choices.

Ï Economists study these choices using economic models, simplified versions ofreality used to analyze real-world economic situations.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

What Is Economics? (Continued)

Ï Here are some examples of scarcity and the trade-offs associated with makingchoices:

Ï You have a limited amount of time. Each hour on the job means one less hour forstudy or play.

Ï A city has a limited amount of land. If the city uses an acre of land for a park, ithas one less acre for housing, retailers, or industry.

Ï You have limited income this year. If you spend $17 on an album, that’s $17 lessyou have to spend on other products or to save.

Ï The Three Key Economic Questions: What, How, and for Whom?Ï The choices made by individuals, firms, and governments answer three

questions:1. What products do we produce?2. How do we produce the products?3. Who consumes the products?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Economic Questions

Ï Two big questions summarize the scope of economics:Ï How do choices end up determining what, how, and for whom goods and services

get produced?Ï When do choices made in the pursuit of self-interest also promote the social

interest?

Ï What?Ï Goods and services are the objects that people value and produce to satisfy

human wants.Ï Agriculture accounts for, approximately, less than 1 percent of total U.S.

production, manufactured goods for 22 percent, and services for 77 percent.Ï In China, agriculture accounts for 11 percent of total production, manufactured

goods for 47 percent, and services for 43 percent.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Economic Questions (Continued)

Ï How?Ï Goods and services are produced by using productive resources that economists

call factors of production.Ï Factors of production are grouped into four categories:

Ï The “gifts of nature” that we use to produce goods and services are land.Ï The work time and work effort that people devote to producing goods and services is

labor.Ï The quality of labor depends on human capital, which is the knowledge and skill

that people obtain from education, on-the-job training, and work experience.Ï The tools, instruments, machines, buildings, and other constructions that

businesses use to produce goods and services are capital.Ï The human resource that organizes land, labor, and capital is entrepreneurship.

Ï For Whom?Ï Who gets the goods and services depends on the incomes that people earn.

Ï Land earns rent.Ï Labor earns wages.Ï Capital earns interest.Ï Entrepreneurship earns profit.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Microeconomics and Macroeconomics

DefinitionMicroeconomics: The branch of economics that examines the functioning ofindividual industries and the behavior of individual decision-making units – that is,firms and households.Macroeconomics: The branch of economics that examines the economic behaviorof aggregates – income, employment, output, and so on – on a national scale.

Ï Microeconomics looks at the individual unit – the household, the firm, theindustry. It sees and examines the “trees”.

Ï Macroeconomics looks at the whole, the aggregate. It sees and analyzes the“forest”.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Examples of Microeconomic and Macroeconomic Concerns


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

The Diverse Fields of Economics

Economic Field Description

Behavioral economics

uses psychological theories relating to emo-tions and social context to help understandeconomic decision making and policy. Muchof the work in behavioral economics focuseson the biases that individuals have that affectthe decisions they make.

Comparative economic systemsexamines the ways alternative economic sys-tems function. What are the advantages anddisadvantages of different systems?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

The Diverse Fields of Economics (Continued)


Econometrics

applies statistical techniques and data to eco-nomic problems in an effort to test hypothesesand theories. Most schools require economicsmajors to take at least one course in statisticsor econometrics.

Economic development

focuses on the problems of low-income coun-tries. What can be done to promote develop-ment in these nations? Important concernsof development for economists include popu-lation growth and control, provision for basicneeds, and strategies for international trade.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools



Economic history

traces the development of the modern economy.What economic and political events and scientificadvances caused the Industrial Revolution? Whatexplains the tremendous growth and progress ofpost-World War II Japan? What caused the GreatDepression of the 1930s?

Environmental economics

studies the potential failure of the market systemto account fully for the impacts of production andconsumption on the environment and on naturalresource depletion. Have alternative public poli-cies and new economic institutions been effectivein correcting these potential failures?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools



Finance

examines the ways in which households and firms ac-tually pay for, or finance, their purchases. It involvesthe study of capital markets (including the stock andbond markets), futures and options, capital budgeting,and asset valuation.

Health economics

analyzes the health care system and its players: gov-ernment, insurers, health care providers, and patients.It provides insight into the demand for medical care,health insurance markets, cost-controlling insuranceplans (HMOs, PPOs, IPAs), government health careprograms (Medicare and Medicaid), variations in med-ical practice, medical malpractice, competition versusregulation, and national health care reform.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools



The history of economic thought,

which is grounded in philosophy, studies the devel-opment of economic ideas and theories over time,from Adam Smith in the eighteenth century to theworks of economists such as Thomas Malthus, KarlMarx, and John Maynard Keynes. Because eco-nomic theory is constantly developing and chang-ing, studying the history of ideas helps give mean-ing to modern theory and puts it in perspective.

Industrial organizationlooks carefully at the structure and performance ofindustries and firms within an economy. How dobusinesses compete? Who gains and who loses?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools



International economics

studies trade flows among countries and inter-national financial institutions. What are theadvantages and disadvantages for a countrythat allows its citizens to buy and sell freelyin world markets? Why is the dollar strong orweak?

Labor economics

deals with the factors that determine wagerates, employment, and unemployment. Howdo people decide whether to work, how muchto work, and at what kind of job? How have theroles of unions and management changed inrecent years?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools



Law and economics

analyzes the economic function of legal rules andinstitutions. How does the law change the behav-ior of individuals and businesses? Do different li-ability rules make accidents and injuries more orless likely? What are the economic costs of crime?

Public economics

examines the role of government in the economy.What are the economic functions of government,and what should they be? How should the govern-ment finance the services that it provides? Whatkinds of government programs should confront theproblems of poverty, unemployment, and pollu-tion? What problems does government involve-ment create?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools



Urban and regional economics

studies the spatial arrangement of economicactivity. Why do we have cities? Why are man-ufacturing firms locating farther and fartherfrom the center of urban areas?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Non Sequitur : Random Famous People Who Majored inEconomics

5. John Elway – Hall of Fame NFL quarterback (Stanford)

4. Bob Barker – TV Game Show host on The Price Is Right (Drury College)

3. Mick Jagger – Rolling Stones (London School of Economics)

2. Arnold Schwarzenegger – Body Builder/Actor/Governor/Terminator(University of Wisconsin)

1. William Shatner – “Khaaaan!” (McGill University)William Shatner “Sings” ‘Rocket Man’ (1978)


https://www.youtube.com/watch?v=lul-Y8vSr0I

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools









Definition



EconomicMethods


EconomicsPolicy

Analytical Tools









Definition



EconomicMethods


EconomicsPolicy

Analytical Tools









Definition



EconomicMethods


EconomicsPolicy

Analytical Tools









Definition



EconomicMethods


EconomicsPolicy

Analytical Tools









Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost

Ï Individuals, firms, and governments must decide on the goods and servicesthat should be produced.

Ï An increase in the production of one good requires the reduction in theproduction of some other good. This is a trade-off, resulting from the scarcity ofproductive resources.

Ï The highest-valued alternative given up in order to engage in some activity isknown as the opportunity cost.

DefinitionOpportunity cost: The best alternative that we forgo, or give up, when we make achoice or a decision.

Ï Example: the opportunity cost of increased funding for space explorationmight be giving up the opportunity to fund cancer research.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost (Continued)

Ï What is your opportunity cost of going to a Chicago Blackhawks game?Ï Opportunity cost has two components:

1. The price of the ticket (explicit cost).2. The things you cannot afford to buy if you purchase the ticket and the things you

cannot do with your time if you attend the game (implicit cost).

DefinitionExplicit costs: Costs requiring a money payment.Implicit costs: Costs not requiring a money payment.

Ï A common pitfall is to ignore implicit costs.

Ï Opportunity cost includes both explicit and implicit costs.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost – Example

Ï Over the last 60 years, the frozen food market has boomed.

Ï In 2012, sales were $44 billion, about 44 times what they were in the mid-1950s.

Ï Increased labor force participation by women has increased the opportunitycost of their time. In other words the cost of preparing meals “from scratch” hasrisen.

Ï A second factor complementing this is a technological improvement, theintroduction of the microwave oven. In fact, the widespread acceptance ofmicrowave ovens occurred because of the increasing opportunity cost of timefor housework.

Ï Entrepreneurs look for areas in which opportunity cost is rising to get someideas about new technology.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost – Example

Ï This example shows how an increase in productivity in one sector of theeconomy can actually raise the opportunity cost of production in other sectors.

Ï During the mid-1980s, the lumber industry announced that a cord of wood (a4-by-4-by-8 foot pile) could be converted into 942 one-pound books, 2,000pounds of paper, 61,370 number 10 envelopes, or 7,500,000 toothpicks.Measure the opportunity cost of books in terms of “toothpicks forgone”. Giventhe data above, the opportunity cost of a book is 7,500,000/942 = 7,961toothpicks per book. Suppose that a technological advance in the toothpickindustry (perhaps a waste-reducing technique) enables more toothpicks, say9,000,000, to be created from a cord of wood.

Ï Question: What happens to the opportunity cost of producing a book whenproductivity increases in the toothpick manufacturing industry?

Ï Answer: The opportunity cost of producing a book increases. Now, one book“costs” 9,000,000/942 = 9,554 toothpicks, even though there has been nochange in book-producing technology.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost – Practice

1. Suppose your expenses for this term are as follows: tuition: $5,000, room andboard: $3,000, books and other educational supplies: $500. Further, during theterm, you can only work part-time and earn $4,000 instead of your full-timesalary of $10,000. What is the opportunity cost of going to college this term,assuming that your room and board expenses would be the same even if you didnot go to college?

Explicit costs = $5,000 + $500 = $5,500Implicit costs = $10,000 − $4,000 = $6,000Opportunity cost = explicit cost + implicit cost = $5,500 + $6,000 = $11,500

2. Steven lives in a big city where there is a shortage of parking. He has a parkingspot in his driveway where he parks his car. True or False: The opportunity cost ofusing the parking spot is the price he could charge someone else for using thespot.True.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools


1. Suppose your expenses for this term are as follows: tuition: $5,000, room andboard: $3,000, books and other educational supplies: $500. Further, during theterm, you can only work part-time and earn $4,000 instead of your full-timesalary of $10,000. What is the opportunity cost of going to college this term,assuming that your room and board expenses would be the same even if you didnot go to college?Explicit costs = $5,000 + $500 = $5,500Implicit costs = $10,000 − $4,000 = $6,000Opportunity cost = explicit cost + implicit cost = $5,500 + $6,000 = $11,500

2. Steven lives in a big city where there is a shortage of parking. He has a parkingspot in his driveway where he parks his car. True or False: The opportunity cost ofusing the parking spot is the price he could charge someone else for using thespot.

True.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools


1. Suppose your expenses for this term are as follows: tuition: $5,000, room andboard: $3,000, books and other educational supplies: $500. Further, during theterm, you can only work part-time and earn $4,000 instead of your full-timesalary of $10,000. What is the opportunity cost of going to college this term,assuming that your room and board expenses would be the same even if you didnot go to college?Explicit costs = $5,000 + $500 = $5,500Implicit costs = $10,000 − $4,000 = $6,000Opportunity cost = explicit cost + implicit cost = $5,500 + $6,000 = $11,500

2. Steven lives in a big city where there is a shortage of parking. He has a parkingspot in his driveway where he parks his car. True or False: The opportunity cost ofusing the parking spot is the price he could charge someone else for using thespot.True.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost (Continued)

Ï Opportunity Cost Is Subjective.Ï Like beauty, opportunity cost is in the eye of the beholder.Ï Only the individual making the choice can identify the most attractive alternative.Ï But the chooser seldom knows the actual value of what was passed up, because that

alternative is “the road not taken” (counterfactual).Ï For example, If you give up an evening of pizza and beer with friends to work on a research

paper, you will never know exactly what you gave up. You know only what you expected.Ï Calculating Opportunity Cost Requires Time and Information

Ï Economists assume that people rationally choose the most valued alternative. This doesnot mean you exhaustively assess the value of all possibilities.

Ï Because learning about alternatives is costly and time consuming, some choices arebased on limited or even wrong information.

Ï For example, trying a new restaurant that turns out to be awful without reading thereviews.

Ï At the time you made the selection, however, you thought you were making the best use ofall your scarce resources, including the time required to gather and evaluate informationabout your choices.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost – Time: The Ultimate Constraint

Ï The Sultan of Brunei is among the richest people on earth, worth billions basedon huge oil revenues that flow into his tiny country. He and his royal family(which has ruled since 1405) live in a palace with 1,788 rooms, including 257bathrooms and a throne room the size of a football field. The family ownshundreds of cars, including dozens of Rolls-Royces; he can drive any of these orpilot one of his seven planes, including the 747 with gold-plated furniture.

Ï Supported by such wealth, the Sultan would appear to have overcome theeconomic problem of scarcity. Though he can buy just about whatever hewants, he lacks the time to enjoy all his stuff.

Ï If he pursues one activity, he cannot at the same time do something else. Eachactivity involves an opportunity cost.

Ï Consequently, the Sultan must choose from among the competing uses of hisscarcest resource, time.

Ï Although your alternatives are less exotic, you too face a time constraint,especially as the college term winds down.


http://en.wikipedia.org/wiki/Hassanal_Bolkiah

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Non Sequitur: Some of The Sultan of Brunei’s Bling Bling


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost – Opportunity Cost Varies WithCircumstance

Ï Opportunity cost depends on your alternatives.Ï This is why you are more likely to study on a Tuesday night than on a Saturday

night.Ï The opportunity cost of studying is lower on a Tuesday night, because your

alternatives are less attractive than on a Saturday night, when more is going on.Ï Suppose you go to a movie on Saturday night. Your opportunity cost is the value

of your best alternative forgone, which might be attending a college game.Ï For some of you, studying on Saturday night may rank well down the list of

alternatives – perhaps ahead of reorganizing your closet but behind doing yourlaundry.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Opportunity Cost – Opportunity Cost Varies WithCircumstance (Continued)

Ï Even religious practices are subject to opportunity cost.Ï For example, about half the U.S. population attends religious services at least

once a month. In some states, so-called blue laws prohibit retail activity onSunday. Some states have repealed these laws in recent years, thus raising theopportunity cost of church attendance. Researchers have found that when a staterepeals its blue laws, religious attendance declines as do church donations. Theseresults do not seem to be linked to any decline in religiosity before the repeal.1

1See Jonathan Gruber and Daniel Hungerman, “The Church vs. the Mall: What Happens WhenReligion Faces Increased Secular Competition?” Quarterly Journal of Economics, 123 (May 2008):831–862.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Diminishing (Marginal) Returns

Definition(law of ) diminishing (marginal) returns: The principle that as successive increments ofa variable resource are added to a fixed resource, the marginal product of the variableresource will eventually decrease.

Ï An example:


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Secondary (Tertiary) Effects

DefinitionSecondary effects: unintended consequences of economic actions that may develop slowlyover time as people react to events

Ï Examples:1. In many cities, public officials have imposed rent controls on apartments. The primary

effect of this policy, the effect policy makers focus on (i.e. the one they sell to the public), isto keep rents from rising. Overtime, however, fewer apartments get built because rentingthem becomes less profitable. Moreover, existing rental units deteriorate because ownershave plenty of tenants anyway. Thus, the quality and quantity of housing may decline as aresult of what appears to be a reasonable measure to keep rents from rising. Another issue isignoring how landlords would respond in legally circumventing the policy; e.g., tacking on‘required’ extras to the apartment such as curtains that the tenant must rent from thelandlord for $250 a month in addition to the rent.

2. A macro related example is Congress passing the Smoot-Hawley Tariff Act of 1930 during theGreat Depression. At first the tariff seemed successful. However, the United States’ tradingpartners retaliated. Overall, world trade decreased by approximately 66% between 1929 and1934!


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Incentives

Ï The choices we make depend on the incentives we face.

Ï As incentives change, so do the actions that people will take.

DefinitionIncentive: A reward that encourages an action or a penalty that discourages anaction.

Ï Example: Changes in several factors have resulted in increased obesity inAmericans over the last couple of decades, including:

Ï Decreases in the price of fast food relative to healthful foodÏ Improved non-active entertainment optionsÏ Increased availability of health care and insurance, protecting people against the

consequences of their actions


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Marginal Analysis

Ï While some decisions are all-or-nothing, most decisions involve doing a littlemore or a little less of something.

DefinitionMarginalism: The process of analyzing the additional or incremental costs orbenefits arising from a choice or decision.

Ï Example: Should you watch an extra hour of TV, or study instead?Ï Economists think about decisions like this in terms of the marginal cost and

benefit (MC and MB): the additional cost or benefit associated with a smallamount extra of some action.

Ï Comparing MC and MB is known as marginal analysis.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Marginal Analysis & Utility

DefinitionMarginal analysis: an examination of the effects of additions to or subtractionsfrom a current situationUtility: a measure of pleasure or satisfaction

Ï An example:


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Sunk Costs

Ï Imagine that you have just brewed a pot of coffee for yourself. After drinkingtwo cups you feel satisfied and do not desire any more, yet there is still somecoffee left in the pot.

Ï Would you drink more coffee just so that what you have already bought andbrewed does not go to waste? If so, then in the eyes of classical economics, youhave committed the error of considering sunk costs.

DefinitionSunk costs: costs that cannot be recovered or diverted towards alternative uses.


Definition



EconomicMethods

Economic Theory &Models


EconomicsPolicy

Analytical Tools

Positive vs. Normative

DefinitionNormative (questions) economic analysis: addresses questions that involve valuejudgments. It concerns what ought to happen rather than what did, will, or would happen.Positive (questions) economic analysis: addresses factual questions, usually concerningchoices or outcomes. It concerns what did, will, or would happen.

Ï Economics could convince reasonable people of the truth of the "positive" ("what is")predictions, but economics cannot end a "normative" ("what should be") disagreement.

Ï Note: It is not always possible or at least easy to separate normative from positivestatements. That said, in this course the focus is nearly exclusively focused on positiveeconomic analysis; i.e. the did, will, or would. In answering any exam or problem setquestion I do not care about my, your, or someone else’s opinion.

Ï Note: The word positive does not mean that the answer admits no doubt. On thecontrary, all answers, particularly those involving predictions, involve some degree ofuncertainty. Rather, in this context, positive simply means that the prediction concerns afactual matter.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Positive vs. Normative – Practice

State whether the following statements are positive or normative.

1. College campuses should ban alcohol.

2. UIC is located in Chicago, IL.

3. Increasing the minimum wage in Chicago to $13 per hour will result in lessemployment in Chicago.

4. The United States spends too little on healthcare.

5. UIC is located in Jackson, Mississippi.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Rationality

Ï Economists generally assume that people are rational.

DefinitionRational: Using all available information to achieve your goals.

Ï Rational consumers and firms weigh the benefits and costs of each action andtry to make the best decision possible.

Ï Example: Microsoft doesn’t randomly choose the price of its Windows software;it chooses the price(s) that it thinks will be most profitable.

Ï A key assumption of most economic analysis is that people act rationally,meaning that they act in their own self-interest and respond to incentives.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Economic Theory & Models

DefinitionEconomic theory: a set of ideas about the economy, organized in a logicalframeworkEconomic model: a simplified description of some aspect of the economy or arepresentation of economic phenomenon that takes a mathematical and/or,conceptual, and/or graphical form

Ï Models embody assumptions about individual behavior, market structure andwhat is taken as given (including policy regime).

Ï Usefulness of economic theory or models depends on reasonableness ofassumptions, possibility of being applied to real problems, empirically testableimplications, theoretical results consistent with real-world data.

Ï A primary goal of developing models is to determine what policies can producebetter macroeconomic outcomes.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools


DefinitionAbstraction: means ignoring many details so as to focus on the most importantelements of a problemParsimony: Explain alot with a little

Essentially, all models are wrong, but some are useful.– George Box

Ï Models are abstractions from reality and should be simplified to focus on onlythe most crucial elements to explain economic phenomena.

Ï Abstraction from unimportant details is necessary to understand thefunctioning of anything as complex as the economy.

Ï Models do not need to be “realistic”, but should be consistent with the facts.Ï May need to switch between models according to context; no grand “true”

model.Dennis C. Plott (UIC) Introduction to Economics with Extensions ECON 121 – Summer 2015 37 / 77

Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Economic Theory & Models: Example

Ï Suppose you are new to UIC.

Ï To navigate your way aroundcampus you consult a map.

Ï What makes a good map?

Ï You can list numerous attributes,but the most important aspect of agood map is that it helps you getfrom point A to point B.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools


DefinitionEndogenous variable: a variable that is explained by an economic modelExogenous variable: a variable that is taken as given and is not explained by aneconomic model

Ï A solution to a model gives the endogenous variables in terms of the exogenousvariables.

Ï Variables that are exogenous in some models might be endogenous in othermodels.

Ï For example, in one macro model, we might take interest rates as exogenous.Ï But some economic models are designed exactly to explain interest rates.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

What Economics Is Not

Ï Economics wants to be physics (or chemistry or biology, etc.). Why is physicsand the like enviable? They have controlled experiments.

Ï There are relatively few controlled experiments in economics and they tend tobe relatively small in size and scope.

Ï Why? Two main reasons:1. The costs for large social experiments tend to be prohibitive.2. A more important concern is that many of the experiments economists would like

to perform, if they were even feasible, would likely be ethically questionable.

Ï For example, what if an economist wanted to determine how Governmentspending would impact an economy experiencing a level of unemployment likethe peak level during the Great Depression (approximately 25%).

Ï So, let’s randomly layoff/fire 15%–20% more of the labor force.

Ï What do you think would happen?


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Ceteris Paribus

Ï In the theoretical models, like the ones used in this class, economists use ceterisparibus.

DefinitionCeteris paribus (“all else equal”): A device used to analyze the relationship betweentwo variables while the values of other variables are held unchanged.

Ï This Latin phrase acts along the lines of a thought experiment and roughlytranslates to "if all other relevant things remain the same" or "holding otherthings constant" or "all other things being equal".

Ï Using the device of ceteris paribus is one part of the process of abstraction. Informulating economic theory, the concept helps us simplify reality to focus onthe relationships that interest us.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Example: London Addresses Its Congestion Problem

Ï To illustrate the economic way of thinking, let’s consider again how an economistwould approach the problem of traffic congestion.

Ï Each driver on the highway slows down other drivers but ignores these time costs whendeciding whether to use the highway.

Ï If the government imposes a congestion tax to reduce traffic during rush hour, theeconomist is faced with a question: How high should the tax be?

Ï Use assumptions to simplify.We assume every car has the same effect on the travel time ofother cars.

Ï Isolate variables – ceteris paribus. We would make the ceteris paribus assumption thateverything else that affects travel behavior – the price of gasoline, bus fares, and consumerincome – remains fixed.

Ï Think at the margin.We would estimate the effects of adding one more car to the highway.

Ï If the marginal driver forces each of the 900 commuters to spend two extra seconds onthe highway, total travel time increases by 30 minutes.

Ï If the value of time is, say, $16 per hour, the appropriate congestion tax would be $8(equal to 16×1/2 hour).


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Example: Consumption Function

Ï Theory: What kind of factors might influence household spending behavior;i.e., consumption?

1. Income (Y )2. Taxes (T)3. Real Interest Rate (r)4. Expected Future Income (E[Y ])5. Wealth6. Weather7. If it is the third Tuesday of the month8. . . . etc . . .


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Economic Theory & Models: Mathematical Functions

Functional notation is used to express the idea that one variable is determined byother variables.

Ï Macroeconomic ExampleÏ Model aggregate consumption as depending on disposable income (Y −T) and

the real interest rate (r):C = C(Y −T ,r)

Ï In this model, income (Y ), taxes(T), and the interest rate (r) are exogenous; whileconsumption (C) is endogenous.

Ï C = C(·) is functional notation indicating consumption (C) is a function of what isinside the parentheses.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools


DefinitionPositive (direct) relationship: A relationship between two variables that move in thesame direction.; the relationship between two variables that change in the samedirection, for example, product price and quantity supplied; positive relationship.Negative (inverse) relationship: A relationship between variables that move inopposite directions.


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools


Ï Question?Ï The functional notation C = C(Y −T ,r) indicates consumption depends on

disposable income and the real interest rate, but how are they related?Ï In other words, how would consumption change with an in increase in the real

interest rate (↑ r) or disposable income (↑ (Y −T)), ceteris paribus? [Hint:positively, negatively, or both (depending on context)?]


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Consumption Example in Practice

In theory there is no difference between theory and practice. In practice there is.– Yogi Berra

Real Interest Rate Consumption2009 1.9 9077.32010 2.5


Definition



EconomicMethods



EconomicsPolicy

Analytical Tools

Non Sequitur : Some Famous Yogi Berra Quotes

Ï “It’s like deja vu all over again.”

Ï “We made too many wrong mistakes.”

Ï “A nickel ain’t worth a dime anymore.”

Ï “Nobody goes there anymore because it’s too crowded.”

Ï “It ain’t over till it’s over.”


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Common Economic Fallacies

Definitionloaded terminology: terms that contain the prejudice and value judgments ofothers; related terms include "appeal to emotion", "inflammatory language", etc.

Ï It is very difficult for a person to describe economic behavior without lettingtheir opinions about that behavior creep into their discussion. The distinctionbetween positive and normative statements is not always clearly apparent.

Ï Often, however, there is a deliberate attempt to sway opinion by using loadedterminology (e.g., "greedy owners", "obscene profits", "exploited workers","mindless bureaucrats", "costly regulations", "creeping socialism").


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools


Definitionfallacy of composition: what is true for one individual or part of a whole isnecessarily true for a group of individuals or the whole; the false notion that what istrue for the individual (or part) is necessarily true for the group (or whole).

Ï Examples:Ï An individual stockholder’s sales of shares vs. a large number of stockholders

selling large numbers of shares.Ï At a football game the person in front of you obstructs your view, so you stand up

to get a better view vs. if everyone in the stadium stands up to get a better view.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools


DefinitionCounterfactual: expressing what has not happened but could, would, or mightunder differing conditions. Counterfactuals are what ifs, thought experiments,alternatives to actual history; they imagine what would have happened to aneconomy if, contrary to fact, some present condition were changed.

Ï When you want to know the causal effect of an intervention (policy change, medicaltreatment, whatever) on something, you need to compare two states of the world: theworld in which the intervention occurred and the world in which it did not. The latteris the counterfactual world. Since most of us only get to live in one world (most of thetime), observing the counterfactual is a rather tricky thing to do.

Ï Example: The stimulus was predicted to hold unemployment below 8.5%; it did not.Did the stimulus fail? It depends on the counterfactual of what would unemploymenthave been without the stimulus? The prediction was wrong, but that doesn’t tell youwhat would have happened without the stimulus.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Schrödinger’s Cat (A Thought Experiment)


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Schrödinger’s Cat (A Thought Experiment)

Ï Schrödinger said that if you put a cat in a box with a poison that might kill it, atthe end of an hour the cat has a 50% chance of being alive, and a 50% chance ofbeing dead. According to quantum mechanics (the branch of physics dealingwith physical phenomena at nanoscopic (immensely small) scales), since wecan’t see in the box to know if the cat is alive or dead, the cat is both alive anddead. Of course, we know that this is not possible (ignoring zombies2), nothingcan be alive and dead at the same time. This is just what Schrödinger wanted toshow.

Ï What does this have to do with economics? Well, if an economist described thethought experiment they could call it a “counterfactual cat” since it isimpossible to observe both states (i.e., dead and alive) of the cat.

2Non sequitur: If you are concerned about a zombie apocalypse see “The Zombie Survival Guide”Dennis C. Plott (UIC) Introduction to Economics with Extensions ECON 121 – Summer 2015 53 / 77

http://www.amazon.com/The-Zombie-Survival-Guide-Protection/dp/1400049628

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

"The Road Not Taken"This poem is a literary analogue to the science example of a counterfactual.

TWO roads diverged in a yellow wood,And sorry I could not travel bothAnd be one traveler, long I stood

And looked down one as far as I couldTo where it bent in the undergrowth;

Then took the other, as just as fair,And having perhaps the better claim,

Because it was grassy and wanted wear;Though as for that the passing there

Had worn them really about the same,

And both that morning equally layIn leaves no step had trodden black.Oh, I kept the first for another day!

Yet knowing how way leads on to way,I doubted if I should ever come back.

I shall be telling this with a sighSomewhere ages and ages hence:

Two roads diverged in a wood, and I–I took the one less traveled by,

And that has made all the difference.

Robert Frost (1874–1963) Mountain Interval 1920


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools


Definitionpost hoc, ergo propter hoc ["after this, therefore because of this"] fallacy: The falsebelief that when one event precedes another, the first event must have caused thesecond event; when two events occur in time sequence, the first event is notnecessarily the cause of the second event.

Ï Example: The Republicans (Democrats) pass a new tax reform law that benefitswealthly Americans. Shortly thereafter the economy takes a nose dive. TheDemocrats (Republicans) claim that the the tax reform caused the economicwoes and they push to get rid of it.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools


Definitioncorrelation versus causation: events may be related without a causal relationshipCorrelation: A systematic and dependable association between two sets of data(two kinds of events); does not necessarily indicate causation.Causation: A relationship in which the occurrence of one or more events bringsabout another event.

Ï Causation vs. Correlation Example:Ï The positive relationship between education and income does not tell us which

causes the increase in the other. (Which is the independent variable and which isthe dependent variable?)

Ï It may be that the increased income that occurs with increased education is dueto some other third factor (an omitted variable) that is not under directconsideration.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Common Economic Fallacies: Causation vs. Correlation

http://www.tylervigen.com/


http://www.tylervigen.com/page?page=3

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

How to Lie with Statistics

There are three kinds of lies: lies, damned lies, and statistics.

The book How to Lie with Statistics by Huff discusses several ways data can bemanipulated to find such striking patterns. Some examples:

Ï Data dredging: selecting statistics that support a particular thesis and drawingattention to those numbers, while ignoring other figures that might lead to adifferent conclusion; cherry picking.

Ï Gee-whiz graphs (truncated Y-axes)

Ï Few points of comparison


http://www.amazon.com/gp/product/0393310728/ref=as_li_tl?ie=UTF8&camp=1789&creative=9325&creativeASIN=0393310728&linkCode=as2&tag=tylervicom-20&linkId=PHGSYIJDF5AQQXY2

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Common Economic Fallacies: Causation vs. Correlation


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

The "Broken Window" Fallacy

Ï In the essay "What Is Seen And What Is Not Seen"3, a 19th Century economistnamed Frederic Bastiat wrote a story about a boy who breaks a shopkeeper’swindow. In replacing it, the shopkeeper gives money to the glassman, and thetown observes that the broken window provided a boost to the local economy.

Ï However, Bastiat emphasizes that this fallacy ignores the unseen fact that, hadthe window not been broken, the shopkeeper would have bought a new pair ofshoes. Hence, there is no net gain for the economy.

Ï Note: this a classic essay with an important point: if you look at only the benefitsof government programs, you miss the hidden costs – where the tax money wouldotherwise have been spent, money unspent due to tariffs, and so forth.

Ï However, Bastiat makes two hidden assumptions:1. All money that is spent would have been spent elsewhere.2. That the replacement for the proverbial broken window is not better in any way.

3http://www.econlib.org/library/Bastiat/basEss1.htmlDennis C. Plott (UIC) Introduction to Economics with Extensions ECON 121 – Summer 2015 60 / 77

http://www.econlib.org/library/Bastiat/basEss1.html

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Straw Man Fallacy

DefinitionStraw Man: an argument that misrepresents a position in order to make it appear weakerthan it actually is, refutes this misrepresentation of the position, and then concludes that thereal position has been refuted.

Ï This sort of “reasoning” has the following pattern:1. Person A has position X.2. Person B presents position Y (which is a distorted version of X).3. Person B attacks position Y.4. Person B then concludes or asserts X is false/incorrect/flawed.

Ï Examples:Ï After Will said that we should put more money into health and education, Warren

responded by saying that he was surprised that Will hates our country so much that hewants to leave it defenseless by cutting military spending.

Ï People who think abortion should be banned have no respect for the rights of women.They treat them as nothing but baby-making machines. That’s wrong. Women must havethe right to choose.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Common Causes of Fallacies

Ï A 1987 study, published in the Journal of the American Veterinary Medical Association, of 132 cats thatwere brought into the New York Animal Medical Center after having fallen from buildings found thatcats falling from five stories or less and nine stories or more had a much greater likelihood ofsurviving than cats who fell between five and nine stories.

Ï Can you explain this? Note: I do not hate cats.Ï In a survey of 200 children those with larger feet consistently scored more highly on a spelling test.Ï Can you explain this?Ï Omitted variable (bias): when a valid or important variable is excluded from a modelÏ Reverse Causation: a reversal of cause and effect or the existence of a feedback relationship

Ï Example: Is health a cause, effect, or both of higher incomes? Higher incomes are expected on balance tolead to better health but better health may enhance productivity growth and hence lead to higherincomes.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Bad Data (Measurement Error) Has Many Causes


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Ï Four criteria in judging economic outcomes:

DefinitionEfficiency: In economics, allocative efficiency. An efficient economy is one thatproduces what people want at the least possible cost.Equity: Fairness.Economic growth: An increase in the total output of an economy.Stability: A condition in which national output is growing steadily, with lowinflation and full employment of resources.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data

UnderstandingBehavioral Equations

Time Subscripts

Ï The time subscript (t) allows us to be more specific about the timing of avariable

Ï The subscript t (current), t −1 (past), or t +1 (future) tells us in which periodsomething is happening

Ï The time subscript (t) can represent any type of data; e.g. annually, quarterly,monthly, etc.

Ï Examples:Ï if we have annual data and t = 2010, then t −1 = 2009 and t +1 = 2011Ï if we have monthly data and t = January 2010, then t −1 = December 2009 and

t +1 = February 2010


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Growth Rates

growth rate = %∆X = Xt+1 −Xt

Xt×100% = Xt+1

Xt−1×100%

Example: Suppose your nominal wage per hour is currently Wt = $12.00 and yourboss states will will get a sixty cent raise per hour; i.e.,Wt+1 = $12.60. What is this inpercentage terms?

%∆W = Wt+1 −Wt

Wt×100%

%∆W = $12.60−$12.00

$12.00×100%

%∆W = 5%

At this rate, assuming you received a five-percent raise per year, how long would ittake for your salary to double?


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Question

Ï Assume you currently do not own any property.Ï Which headline would you prefer if you are planning on purchasing a new

house several years in the future?1. “Housing Prices Have Soared Doubling in the Last Decade”2. “The Market for Housing Grew Moderately at 7% Last Year, Consistent with the

Ten Year Average”

For simplicity, assume the relevant growth rate for these two respectiveheadlines remains constant.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Rule of 70 (72)

DefinitionRule of 70 (72): the approximate amount of time (e.g. years) it takes for the level of avariable growing at a constant rate to double.

T2 ≈ 70

R

whereT2: approximate time for variable to doubleR: constant (average) growth rate percent

Ï Use 70 for numbers ending in 0, 2, 5, 7, and 10Ï Use 72 for numbers ending in 3, 4, 6, 8, and 9

Continuing from the previous slide it would take approximately70

5= 14 years for

your salary to double.Dennis C. Plott (UIC) Introduction to Economics with Extensions ECON 121 – Summer 2015 68 / 77

Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Percentage Points vs. Percent Change

Ï Percentage is relative, while percentage points are absolute.

Ï Generally speaking, percentage points should be used to measure thedifference between two percentages, since it gives a clearer view of thedifferences than when percentages are used.

Ï Example:Ï If we say that the number of female CEOs increase by 3%, we mean that the

number increase with 3% of the current number of female CEOs. If we say thenumber increases with 3 percentage points, we mean that the number of femaleCEOs increase with 3% of the total number of CEOs. So if 5% of all CEOs arefemale a 3% increase would not be noticeable, since it increased the number offemale CEOs to 5.015% of the total number of CEOs. However, if the number offemale CEOs increases with 3 percentage points, this implies 8% of all CEOswould be female. Quite a difference.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Slope

Definition

slope = rise

run= y2 −y1

x2 −x1= y1 −y2

x1 −x2= ∆y

∆x

x

y

y = mx+b

y-intercept

y1

y2

x1 x2

run

rise


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Tangent Lines

Definitiontangent (line): A line that just touches a curve at one point, without cutting across it.

x

y

y = f (x)

tangent to y = f (x)


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Types of Data

DefinitionTime Series: data for the same entity for multiple time periodsCross-Sectional: data collected for different entities in a single time periodPanel: data for multiple entities where each entity is observed in two or more timeperiods

Ï An example of time series data are the daily closing value of the Dow Jones IndustrialAverage.

Ï An example of cross-sectional data is the gross annual income for each of 1000randomly chosen households in New York City for the year 2011.

Ï A famous example is the Panel Study of Income Dynamics (PSID) which primarilycollects economic and demographic information from over 18,000 individuals living inover 5,000 families in the United States.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data


Regression Analysis: Analyzing Theory

Economic theory specifies a set of relationships between variables; e.g., demandequations, production functions, consumption functions, etc.

DefinitionEconometrics: empirically investigate economic theory using data to provideestimates of key (unknown) parameters in economic models; e.g., estimates ofelasticities, marginal propensity to consume, etc.


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data



Ï Theory: What kind of factors might influence household spending behavior;i.e., consumption (cons)?

1. Income (inc)2. Taxes (tax)3. Real Interest rate (int)4. Expected Future Income (E[Y ] = incfut)5. Wealth (wealth)6. Weather (weather)7. ... etc ...


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data



Ï How might we examine the effects of these different factors on consumption?

Ï Set consumption as a function of these variables; i.e., regress consumption on aset of explanatory variables.

Ï Thus the consumption function might look like:

cons =β0 +β1inc+β2tax+β3int +β4incfut +β5wealth+εt


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data



Ï Dependent Variable: cons

Ï Parameters to be estimated: β0,β1,β2,β3,β4,β5

Ï Independent variables: inc, tax, int, incfut,wealth

Ï Error: ε


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data




Ï Given the consumption function above, we would wish to then examine theimpact that the independent variables have on the dependent variable; e.g.,what is the impact of a change in interest rates on consumption?

Ï Answer:∆cons =β3∆int

⇒ ∆cons

∆int=β3

Ï Question: Should the estimated parameter β̂3 be positive or negative?

Ï Answer: Negative (β̂3 < 0)


Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data






⇒ ∆cons

∆int=β3




Definition



EconomicMethods


EconomicsPolicy

Analytical Tools

Graphs

Data






⇒ ∆cons

∆int=β3




Documents

Economics 121 Principles of Macroeconomics Introduction to ...dennisplott.com/uploads/3/1/9/0/31906031/01_uic_econ121_2015su… · Economics 121 Principles of Macroeconomics Introduction