THE ART AND SCIENCE OF ECONOMIC ANALYSIS

© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 1

THE ART AND SCIENCE OF ECONOMIC ANALYSIS

INTRODUCTION

This chapter has two purposes: to introduce students to some of the basic language of economics and to stimulate student interest in the subject. It conveys to students that economics is not only found in the financial section of the newspaper, but also is very much a part of their everyday lives. Beginning with the economic problem of scarce resources but unlimited wants, this chapter provides an overview of the field and the analytical techniques used. Concepts introduced include: resources, goods and services, the economic decision makers in the economy, and marginal analysis. Two models for analysis, the circular flow model and steps of the scientific method, are introduced. The Appendix introduces the use of graphs.

CHAPTER OUTLINE

I.The Economic Problem: Scarce Resources, Unlimited Wants

Economics is about making choices. The problem is that wants or desires are virtually unlimited while the resources available to satisfy these wants are scarce. A resource is scarce when it is not freely available, when its price exceeds zero. Economics studies how people use their scarce resources in an attempt to satisfy their unlimited wants.

• Resources

The inputs, or factors of production, used to produce the goods and services that

people want. Resources are divided into four categories:

1.Labor: Human effort, both physical and mental

2.Capital

•Physical capital: Manufactured items (tools, buildings) used to produce

goods and services.

•Human capital: Knowledge and skills people acquire to increase their

productivity.

3.Natural resources: gifts of nature, bodies of water, trees, oil reserves, minerals and animals.•These can be renewable or exhaustible.

4.Entrepreneurial ability: The imagination required to develop a new product

or process, the skill needed to organize production, and the willingness to take the risk of profit or loss.•Payments for resources: Labor–wage; capital–interest; natural resources– rent; entrepreneurial ability–profit.

• Goods and Services

•A good is something we can see, feel, and touch (i.e., corn). It requires scarce resources to produce and is used to satisfy human wants.•A service is not tangible but requires scarce resources to produce and satisfy human wants (i.e. haircut).•A good or service is scarce if the amount people desire exceeds the amount available at a price of zero. Goods and services that are truly free are not the subject matter of economics. Without scarcity, there would be no economic problem and no need for prices MacroEconomics A Contemporary Introduction, 11e William McEachern (Solutions Manual All Chapters) 1 / 4

• Chapter 1 The Art and Science of Economic Analysis

© 2017 Cengage Learning ® . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.• “There is no such thing as a free lunch.” The lunch may seem free to you, but it draws scarce resources away from the production of other goods and services, and whoever provides a free lunch often expects something in return.

• Economic Decision Makers and Markets

There are four types of decision makers:

• Households. As consumers, demand goods and services produced. As resource

owners, supply resources to the resource market.

• Firms. Use resources that households supply and produce goods and services

that households demand.

• Governments. Use resources that households supply and produce goods and

services that households demand.

• The rest of the world. Use resources that households supply and produce goods

and services that households demand.

• Markets: Buyers and sellers carry out exchanges in markets.

• Goods and services are exchanged in product markets.• Labor, capital, natural resources, and entrepreneurial ability are exchanged in resource markets.

• A Simple Circular Flow Model

• A simple circular flow model in Exhibit 2 describes the flow of resources, products, income and revenue among economic decision makers.II. The Art of Economic Analysis

• Rational Self-Interest

• Economics assumes that individuals, in making choices, rationally select alternatives they perceive to be in their best interests.

• Rational refers to people trying to make the best choices they can, given

the available information.• Each individual tries to minimize the expected cost of achieving a given benefit or to maximize the expected benefit achieved with a given cost.

• Choice Requires Time and Information

Time and information are scarce and therefore valuable. Rational decision makers acquire information as long as the expected additional benefit from the information is greater than its expected additional cost.

• Economic Analysis Is Marginal Analysis

A theory predicting that the standard of living in economies around the world will grow more similar over time, with poor countries eventually catching up with richer ones.• Economic choice is based on the comparison of expected marginal cost and the expected marginal benefit.• Marginal means incremental or additional.• A rational decision maker changes the status quo if the expected marginal benefit from the information is greater than its expected marginal cost. 2 / 4

Chapter 1 The Art and Science of Economic Analysis 3 © 2017 Cengage Learning ® . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Microeconomics and Macroeconomics

• Microeconomics: The study of individual economic choices (e.g., your

economic behavior, a company’s economic behavior).

• Macroeconomics: The study of the performance of the economy as a whole, as

measured, for example, by total production and employment.• Economic fluctuations: The rise and fall of economic activity relative to the long-term growth trend of the economy; also called business cycles.III. The Science of Economic Analysis

• The Role of Theory

An economic theory, or economic model, is a simplification of economic reality that is used to make predictions about cause and effect in the real world. An eco- nomic theory captures the important elements of the problem under study.

• The Scientific Method

A four-step process of theoretical investigation:

• Identify the question and define relevant variables. A variable is a measure

that can take on different values at different times.

2. Specify assumptions:

• Other-things-constant assumption: Focuses on the relationships

between the variables of interest, assuming that nothing else important changes (i.e., ceteris paribus).

• Behavioral assumptions: Focus on how people will behave (i.e., in

their rational self-interest).

• Formulate a hypothesis, a theory about how key variables relate to each

other. The purpose of this hypothesis, like that of any theory, is to help make predictions about cause and effect in the real world

• Test the hypothesis. Compare its predictions with evidence. The theory is

then rejected, accepted, or modified and retested.

• Normative Versus Positive

• A positive economic statement concerns what is; it can be supported or rejected by reference to facts.• A normative economic statement concerns what should be; it reflects an opin- ion and cannot be shown to be true or false by reference to the facts.

• Economists Tell Stories

• Economists explain their theories by telling stories about how they think the economy works. To tell a compelling story, an economist relies on case studies, anecdotes, parables, the personal experience of the listener, and supporting data

• Predicting Average Behavior

• The task of an economic theory is to predict the impact of an economic event on economic choices and, in turn, the effect of these choices on particular mar- kets or on the economy as a whole. Economists focus on the average, or typical, behavior of people in groups.

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• Chapter 1 The Art and Science of Economic Analysis

© 2017 Cengage Learning ® . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

F. Some Pitfalls of Faulty Economic Analysis:

• The fallacy that is association is causation: The fact that one event precedes

another or that two events occur simultaneously does not mean that one caused the other.

2. The fallacy of composition: The incorrect belief that what is true for the

individual, or the part, is true for the group, or the whole.

3. The mistake of ignoring secondary effects: (unintended consequences of

policy)

• If Economist Are So Smart, Why Aren’t They Rich?

• Economists have been appointed to federal cabinet posts, as secretaries of commerce, defense, labor, state, treasury, and to head the U.S. Federal Reserve System.• Economics is the only social science and the only business discipline for which the prestigious Nobel Prize is awarded, and pronouncements by economists are reported in the media daily.

Case Study : College Major and Annual Earnings

IV. Conclusion This textbook describes how economic factors affect individual choices and how all these choices come together to shape the economic system. Economics is not the whole story, and economic factors are not always the most important. But economic considerations have important and predictable effects on individual choices, and these choices affect the way we live.

Appendix: Understanding Graphs

Drawing Graphs • Origin: The point of departure, the point from which all variables are measured.• Horizontal axis: The value of the x variable increases as you move along this axis to the right of the origin; a straight line to the right of the origin.• Vertical axis: The value of the y variable increases as you move upward and away from the origin; a straight line extending above the origin.• Within the space framed by the axes, you can plot possible combinations of the variables measured along each axis.

• Graph: A picture showing how variables relate.

• Time-series graph: Shows the value of one or more variables over time.

• Functional relation: Exists between two variables when the value of one variable depends on the other variable (e.g., the value of the independent variable determines the value of the dependent variable).

• Types of relationships between variables:

• Positive, or direct, relation: As one variable increases, the other variable increases.
• Negative, or inverse, relation: As one variable increases, the other variable decreases.
• Independent, or unrelated relation: As one variable increases, the other variable

remains unchanged or unrelated.

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