Economics is the study of peoples choices.

Economics summaryLH

Chapter 1: The principles and practice of economics

Key ideas Economics is the study of people’s choices.The first principle of economics is that people try to optimize; they try to choose the best available option.The second principle of economics is that economic systems tend to be in equilibrium, a situation in which nobody would benefit by changing his or her own behaviour.The third principle of economics is empiricism —analysis that uses data.Economists use data to test theories and to determine what is causing things to happen in the real world.

1.1 The scope of economics Economic agent is an individual or a group that makes choices.Scarce resources are things that people want, where the quantity that people want exceeds the quantity that is available.Scarcity exists because people have unlimited wants in a world of limited resources.Economics is the study of how agents choose to allocate scarce resources and how those choices affect society.Understanding and studying people’s choices is practically useful for two key reasons.

Economic analysis:

1.Descriptive: Describes what people actually do (positive economics).

2.Advisory: Recommends what people ought to do (normative economics).

Positive economics is stating facts based on data.E.g. some people took more than one candy and not everyone got a piece.Normative economics is giving suggestions. It is dependent on subjective judgments (personal taste, feelings, opinion). The person being advised should determine the preferences to be used.Microeconomics is the study of how individuals, households, firms and governments make choices, and how those affect prices, the allocation of resources, and the well- being of other agents. In general, understanding a small piece of the overall economy.Macroeconomics is the study of the whole economy. Macroeconomists study economy-wide phenomena, and design government policies that improve overall, or ‘’aggregate’’, economic performance.

1.2 Three Principles of Economics

Economists emphasize three key concepts:

1.Optimization: making the best choice possible with given information.

2.Equilibrium: when everyone is simultaneously optimizing; no one would be

better off with a different choice.

3.Empiricism: analysis that uses data (evidence-based). Economists use data to

test theories and to determine what is causing things to happen in the world. 1 / 4

Economics summaryLH

1.3 The first principle of Economics: Optimization

Economic agents optimize by choosing the best feasible option with the information they have. Feasible options are those who are available, affordable and executable to an economic agent.The definition of optimization also refers to the information available at the time of choice.Optimization means that we weigh the potential risks in a decision, not that we perfectly foresee the future.When someone chooses the best feasible option, he/she is being rational. Rational action requires a logical appraisal of costs, benefits and risks associated with each other.Note that the test of optimization is the quality of your decision, and not the outcome. In cases where agents fail to optimize, normative economic analysis can help them realize their mistakes and make better choices in the future.Trade-offs arise when someone benefits must be given up to gain another.Budget constraint is the bundles of goods or services that a consumer can choose given her limited budget.E.g. when you spend an hour on Facebook, you cannot spend that hour working.

To describe this trade-off, the budget constraint is used:

• hours = Hours on Facebook + Hours working

If you spend an extra hour on Facebook, you need to spend one less hour on working.Opportunity cost is the best alternative use of a resource.Assigning a monetary value to an opportunity cost makes it easier to analyse.Cost-benefit analysis is a calculation that adds up costs and benefits using a common unit. It is used to identify the alternative that has the greatest net benefit, which is equivalent to benefits minus costs.

1.4 The second principle of Economics: Equilibrium

In an equilibrium, nobody perceives that they would benefit from changing their behaviour.The information they consider, also includes their beliefs of other’s behaviour.The Free-Rider Problem exists when an individual or group can enjoy the benefits of a situation without incurring the costs.

1.5 The third principle of economics: Empiricism

Empiricism is an evidence-based analysis where economists test their ideas with data, to see if the theories about human behaviour match up with reality. They distinguish causation and correlation. 2 / 4

Economics summaryLH

Chapter 2: Economic methods and economic questions

Key ideas A model is a simplified description of reality.Economists use data to evaluate the accuracy of models and understand how the world works.Correlation is not the same thing as causality.Experiments help economists to measure cause and effect.Economic research focuses on questions that are important to society and can be answered with models and data.

2.1 The scientific method

The scientific method (empiricism) is composed of two steps:

1.Developing models that explain some part of the world.

2.Testing those models using data to see how closely the model matches with what we observe.Model is a simplified description of reality.Two important features of models oThey are not exact. Not everyone will see their wages increase by 10% with every additional year of education.oThey generate predictions that can be testes with data.Empirical evidence is a set of facts established by observation and measurement.Hypotheses are predictions that can be tested with data.

2.2 Causation and correlation Causation is when one thing directly affects another.E.g. pulling an all-nighter will make you tired.Correlation is when two things are related; one changes, the other changes as well.Positive correlation – they both change in the same direction.Negative correlation – they change in opposite directions.Zero correlation – they are not related.Why isn’t correlation the same thing as causality?

1.Omitted variables Something that has been left out of a study, if included, would explain why two variables are correlated.

2.Reverse causality When we mix up the direction of cause and effect.How can we tell the difference between causality and correlation?Experiment is a controlled method of investigating causal relationships among variables.Controlled – subjects are randomly put into treatment (something happens) and control (nothing happens) groups by the researcher.

Problem: difficult to do with economic studies.

Natural – subjects end up in treatment or control groups due to something that is not purposefully determined by the researcher.Randomization is the assignment of subjects by chance, rather than by choice, to a treatment group or control group. 3 / 4

Economics summaryLH

Two properties of a good economic question:

1.Relevant and important Economic research contributes to social welfare.

2.Can be answered Economic questions can be answered empirically.

Chapter 3 Optimization: doing the best you can

Key ideas When an economic agent chooses the best feasible option, she is optimizing.Optimization in levels calculates the total net benefit of different alternatives and then chooses the best alternative.Optimization in differences calculates the change in net benefits when a person switches from one alternative to another, and then uses these marginal comparisons to choose the best alternative.Optimization in levels and optimization in differences give identical answers.

3.1 Two kinds of optimizations: a matter of focus

Behavioural economics jointly analyses the economic and psychological factors that explain human behaviour.

3.2 Optimization in levels Comparative statics is the comparison of economic outcomes before and after some economic variable is changed.Optimizing in levels calculates the change in net benefits when a person switches from one option to another and then chooses the best alternative.

1.Express all costs and benefits in the same unit.

2.Calculate total net benefit (benefits – costs) for each option.

3.Choose the option with the highest net benefit.

3.3 Optimization in differences

Decision-making using marginal analysis:

E.g. comparison of choosing an apartment near work:

Principle of optimization at the margin If an option is the best choice, you will be made better off as you move toward it and worse off as you move away from it.Optimizing in differences calculates the change in net benefits when a person switches from one alternative to another and uses these marginal comparisons to choose the best alternative.

1.Express all costs and benefits in the same unit.

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