The Scope and Method of Economics

PRINCIPLE OF ECONOMIC

6 EDITION

KARL CASE, RAY FAIR

PRENTICE HALL BUSINESS PUBLISHING

COPY RIGHT 2002

The Study of Economics

•         Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.

Why Study Economics?

•         Probably the most important reason for studying economics is to learn a way of thinking.

•         Three fundamental concepts:

•         Opportunity cost

•         Marginalism, and

•         Efficient markets

Opportunity Cost

•         Opportunity cost is the best alternative that we forgo, or give up, when we make a choice or a decision.

•         Opportunity costs arise because time and resources are scarce.  Nearly all decisions involve trade-offs.

Marginalism

•         In weighing the costs and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision.

•         For example, when deciding whether to produce additional output, a firm considers only the additional (or marginal cost), not the sunk cost.

•         Sunk costs are costs that cannot be avoided, regardless of what is done in the future, because they have already been incurred.

Efficient Markets

•         An efficient market is one in which profit opportunities are eliminated almost instantaneously.

•         There is no free lunch!  Profit opportunities are rare because, at any one time, there are many people searching for them.

More Reasons to Study Economics

•         Economics involves the study of societal and global affairs concerning resource allocation.

•         Economics is helpful to us as voters.  Voting decisions require a basic understanding of economics.

•         Money and financial systems are an important component of the economic system, but are not the most fundamental issue in economics.

The Scope of Economics

•         Microeconomics is the branch of economics that examines the functioning of individual industries and the behavior of individual decision-making units—that is, business firms and households.

•         Macroeconomics is the branch of economics that examines the economic behavior of aggregates— income, output, employment, and so on—on a national scale.

The Method of Economics

•         Normative economics, also called policy economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action.

•         Positive economics studies economic behavior without making judgments.  It describes what exists and how it works.

•         Positive economics includes:

•         Descriptive economics, which involves the compilation of data that describe phenomena and facts.

•         Economic theory that involves building models of behavior.  A theory is a statement or set of related statements about cause and effect, action and reaction.

•         Empirical economics refers to the collection and use of data to test economic theories.

Theories and Models

•         A theory is a general statement of cause and effect, action and reaction.  Theories involve models, and models involve variables.

•         A model is a formal statement of a theory.  Models are descriptions of the relationship between two or more variables.

•         Ockham’s razor is the principle that irrelevant detail should be cut away.  Models are simplifications, not complications, of reality.

•         A variable is a measure that can change from observation to observation.

•         Using the ceteris paribus, or all else equal, assumption, economists study the relationship between two variables while the values of other variables are held unchanged.

•         The ceteris paribus device is part of the process of abstraction used to focus only on key relationships.

•         In formulating theories and models we must avoid two pitfalls:

•         The Post Hoc Fallacy:  It is erroneous to believe that if event A happened before event B, then A caused B.

•         The Fallacy of Composition:  It is erroneous to believe that what is true for a part is also true for the whole.  Theories that seem to work well when applied to individuals often break down when they are applied to the whole.

Economic Policy

Criteria for judging economic outcomes:

•         Efficiency, or allocative efficiency.  An efficient economy is one that produces what people want at the least possible cost.

•         Equity, or fairness of economic outcomes.

•         Growth, or an increase in the total output of an economy.

•     Stability, or the condition in which output is steady or growing, with low inflation and full employment of resources.