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1 Getting Started CHAPTER CHECKLIST When you have completed your study of this chapter, chapter you will be able to 1 Define economics and explain the questions that economists try to answer. 2 Explain the core ideas that define the economic way of thinking. © 2011 Pearson Education 1.1 DEFINITION AND QUESTIONS All economic questions and problems arise because human wants exceed the resources available to satisfy them. them Scarcity Scarcity is the condition that arises because wants exceeds the ability of resources to satisfy them. Faced with scarcity, we must make choices —we must choose among the available alternatives. The choices we make depend on the incentives we face. 1.1 DEFINITION AND QUESTIONS Economics Defined Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity, scarcity the incentives that influence those choices, and the arrangements that coordinate them. Jacob J b Vi Viner: “E “Economics i iis what h economists i do.” Jim Duesenberry: “Economics is all about how people make choices. Sociology is about why there isn isn’tt any choice to be made made.” 1.1 DEFINITION AND QUESTIONS Two big economic questions: • How do choices determine what, what how, how and for whom goods and services get produced? • When do choices made in self-interest also promote the social interest? What, How, and For Whom? What goods and services get produced and in what quantities? How are goods and services produced? For Whom are the various g goods and services produced? The price of oil Tripled in 1973 1973-74, 74, and doubled again in 1979 1979-80 80 … and affected people all over the world. 60 US$ per b barrel 50 40 30 20 10 0 1965 1970 1975 Source:McGraw-Hill, 2005 1980 1985 1990 1995 2000 An increase in the price of oil affects What to produce less oil-intensive products How to produce p less oil-intensive techniques For whom to produce oil producers have more buying power, importers have less ...are the goods produced go to the people who benefit most from them? Source:McGraw-Hill, 2005 When Is the Pursuit of Self-Interest in the Social Interest? The choices that are best for the individual who pursuit of makes them are choices made in the p self-interest. The choices that are best for society as a whole are choices made in the social interest. A Beautiful Mind A Beautiful Mind 3 11 flv A_Beautiful_Mind_3_11_.flv Beautiful Mind Script Nash : If we all go for the blonde...we block each other. Not a single one of us is gonna get her. So then we go for her friends, but they will all give us the cold shoulder because nobody likes to be second choice. Well, what if no one goes for the blonde? We don't get in each other's way, and we don't insult the other girls.That's the only way we win. …. Because the best result will come...from come from everyone in the group doing what's best for himself...and the group. http://adamsmithslostlegacy.blogspot.com/2009/02/ hollywood-john-nash-was-wrong.html 1.1 DEFINITION AND QUESTIONS Can choices made in self-interest also serve the social interest? 1 Financial Crisis and Global Slump The bankers Th b k th t were eager to that t lend l d to t home h buyers between 2000 and 2006 were pursuing their self-interest. Borrowers and homebuyers also acted in what they saw as their th i self-interest. lf i t t An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. Additionally, there were economic incentives provided to the originators of subprime mortgages Once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. difficult Defaults and foreclosure activity increased dramatically. When the housing bubble burst and homeowners defaulted on their loans, they acted in self-interest. When banks foreclosed on borrowers, they acted in selfinterest. But B t these th actions ti were nott in i the th social i l iinterest. t t The ongoing foreclosure epidemic, of which subprime loans are one part, that began in late 2006 in the U.S. continues to be a key factor in the global economic crisis, because it drains wealth from consumers and erodes the financial strength of banking institutions. 2 Globalization and International Outsourcing Globalization Gl b li ti and d iinternational t ti l outsourcing t i (production of components &services by firms in other countries) are in the interest of owners of multinational firms that profit (they have lower production costs in China, India..), but is it in the social interest? How about the displaced American worker? Or the worker in Malaysia who works for a few cents/hour? 3 The Information-Age Information Age Economy Makers of computer chip and programs developed products in their self-interest self interest but did they develop their products in the social interest? Were resources used in the best way? Did Intel made the best possible chips and sold it att the th right i ht prices? i ? 4 Disappearing pp g Rainforests and Fish Stocks When we buy yp products made with ingredients from rainforests are we damaging the social interest? ....at the current rate of destruction almost all tropical rainforest ecosystems will be gone by 2030 5 Water W t Shortages Sh t Are the global water resources managed in the self interest or in the social interest? self-interest 6 Global Warming The choices we make concerning how to produce and use energy are made d iin our self-interest, lf i t t but b t do d they th serve the social interest? ....Would the US signing onto the Kyoto Protocol (agreement that seeks binding emission cuts) serve the social interest? 1.2 THE ECONOMIC WAY OF THINKING How economists approach their work Core Economic Ideas: • • • • • Rational choice Cost Benefit f Margin Incentives 1.2 THE ECONOMIC WAY OF THINKING Rational Choice A rational choice is a choice that uses the available resources to t best b t achieve hi the th objective bj ti off the th person making the choice. We make rational choices by comparing costs and benefits. ……….why are u here in college? 1.2 THE ECONOMIC WAY OF THINKING Cost: What You Must Give Up Opportunity cost is the best thing that you must give i up tto gett something—the thi th hi highest-valued h t l d alternative forgone. ....how how much would u be making monthly if u were working? Sunk cost is a previously incurred and irreversible cost. A sunk cost is not part of the opportunity cost of a current choice. ….u have already paid the tuition 1.2 THE ECONOMIC WAY OF THINKING Benefit: Gain Measured by What You Are Willing to Give Up Benefit is the gain or pleasure that something brings. On the Margin (border/edge) A choice made on the margin is a choice made by comparing all the relevant alternatives systematically and incrementally. 1.2 THE ECONOMIC WAY OF THINKING Marginal Cost Marginal cost is the cost of a one-unit increase in an activity.….seeing an additional movie lowers your grade more and more…MC increasing Marginal Benefit Marginal benefit is the what you gain when you get one more unit of something. something …eating eating 1 more slice of pizza gives less and less pleasure..MB decreasing 1.2 THE ECONOMIC WAY OF THINKING Making a Rational Choice When we take those actions for which marginal benefit exceeds or equals marginal cost. ….delaying graduation..Cost? Benefit? Responding to Incentives An incentive is a reward or a p penalty—a y “carrot” or a “stick”—that encourages or discourages an action. 1.2 THE ECONOMIC WAY OF THINKING Micro and Macro Views of the World Microeconomics: The studyy of the choices that individuals and businesses make and the way these choices interact and are influenced by governments. Macroeconomics: The study of the aggregate (or total) effects on the national economy and the global economy of the choices that individuals, individuals businesses businesses, and governments make. 1.2 THE ECONOMIC WAY OF THINKING Economics as a Social Science Economists distinguish between • Positive statements: What is …the unemployment rate is 9.4% • Normative N ti statements: t t t What Wh t ought ht to t be….the b th government should change its unemployment p y policy The task of economic science: To test positive statements about how the economic world works and to weed out those that are wrong. 1.2 THE ECONOMIC WAY OF THINKING Ceteris paribus means “other things being equal” or “other things remaining the same.” By changing one factor at a time and holding other relevant factors constant, we are able to investigate the effects of the factor. 1.2 THE ECONOMIC WAY OF THINKING In the real world, we observe the outcomes of simultaneous operation of many factors factors. How to solve the problem? T sortt off the To th effects ff t off each h factor, f t economists i t use • Natural experiments • Statistical investigations • Economic experiments 1.2 THE ECONOMIC WAY OF THINKING 1. Natural experiments: A situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal/similar. Ex: Canada has higher unemployment benefits than US US. Compare th C the effects ff t off UB on the th unemployment l t rate t in i US and Canada.. 1.2 THE ECONOMIC WAY OF THINKING 2. A statistical investigation looks for a correlation. Correlation is the tendency for the values of two variables i bl tto move ttogether th ((same / opposite it direction) di ti ) iin a predictable and related way… smoking & lung cancer, education & income 3. An economic experiment puts people in a decisionmaking situation and varies the influence of one factor at a time to discover how they respond. 1.2 THE ECONOMIC WAY OF THINKING Economics as Policy Tool Economics provides a way of approaching problems in allll aspects t off our lives: li Personal (should you take a student loan?), Business (Should Taxeco get more oil from Gulf of Mexico or Alaska?), and Government (How can California balance its budget?). Getting Started CHAPTER APPENDIX: MAKING AND USING GRAPHS 1 APPENDIX: MAKING AND USING GRAPHS Basic Idea A graph enables us to visualize the relationship between two variables. To make a graph, set two lines perpendicular to each other: • The horizontal line is called the x-axis. • The vertical line is called the y-axis. point is called the origin. g • The common zero p APPENDIX: MAKING AND USING GRAPHS Point A shows that when the temperature is 40 degrees, ice cream consumption is only 5 gallons a day day. Point B shows that when the temperature is 80 degrees, ice cream consumption jumps to 20 gallons a day. APPENDIX: MAKING AND USING GRAPHS Interpreting Data Graphs Scatter diagram is a graph of the value of one variable against the value of another variable. Time series graph is Time-series i a graph h th thatt measures titime on the x-axis and the variable or variables in which we are interested on the y-axis. y APPENDIX: MAKING AND USING GRAPHS Figure A1.2(a) shows a scatter diagram. In 2000 (marked 00), income per person was $25 $25,500 500 and expenditure per person was $23,900. The data for 1995 to 2005 show that as income increases increases, expenditure increases. APPENDIX: MAKING AND USING GRAPHS Figure A1.2(a) shows a scatter diagram. In 2000 (marked 00), income per person was $25 $25,500 500 and expenditure per person was $23,900. The data for 1995 to 2005 show that as income increases increases, expenditure increases. APPENDIX: MAKING AND USING GRAPHS Trend is a general tendency for the value of a variable to rise or fall. Cross-section graph is a graph that shows the values of an economic variable for different groups in a population at a point in time. Gender/age/income groups APPENDIX: MAKING AND USING GRAPHS Figure A1.2(d) shows a cross-section graph. g p The graph shows the percentage of people who participate p p in various sports activities. APPENDIX: MAKING AND USING GRAPHS Interpreting Graphs Used in Economic Models Positive relationship or direct relationship is a relationship between two variables that move in the same direction. Linear relationship is a relationship that graphs as a straight t i ht line. li APPENDIX: MAKING AND USING GRAPHS Figure A1.3(a) Fi A1 3( ) shows h a positive (direct) relationship. At a speed of 40 MPH MPH, you travel 200 miles in 5 hours—point A. At a speed of 60 MPH, you travel 300 miles in 5 h hours—point i t B. B As the speed increases, the distance traveled in 5 hours increases proportionately. APPENDIX: MAKING AND USING GRAPHS APPENDIX: MAKING AND USING GRAPHS Negative relationship or inverse relationship is a relationship between two variables that move in opposite directions. directions APPENDIX: MAKING AND USING GRAPHS Figure A1.4(a) shows a negative (inverse) relationship. As the time playing tennis increases, the time playing squash decreases decreases. Because one more hour of tennis means one hour less of squash, squash the relationship between these two variables is described by a g line. straight APPENDIX: MAKING AND USING GRAPHS MAX AND MIN Unrelated Variables APPENDIX: MAKING AND USING GRAPHS The Slope of a Relationship Slope p equals q the change g in the value of the variable measured on the y-axis divided by the change the value of the variable measured on the x-axis. (rise over run) Slope = y ÷ x. APPENDIX: MAKING AND USING GRAPHS Figure A1.7(a) shows a positive iti slope. l 1 When ∆x is 4 1. 4, 2. ∆y is 3. 3. Slope (∆y/∆x) is 3/4. APPENDIX: MAKING AND USING GRAPHS Figure A1.7(b) shows a negative ti slope. l 1 When ∆x is 4 1. 4, 2. ∆y is –3. 3. Slope (∆y/∆x) is –3/4 3/4.