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Chapter 1
Introduction to Economics
Chapter Summary
Economics is a discipline which studies how scarce economic resources are used to
maximize production for a society. Microeconomics studies the economic behavior of
individual units; macroeconomics studies the behavior of aggregates.
Economic theories and models are developed to facilitate the understanding of
complex economic phenomena. Models of economic behavior relate a dependent
variable to a limited number of independent variables. The term ceteris paribus is
used when the value of all but one of the independent variables is held constant.
Economists use tables, graphs, and equations to present modeled behavior Graphs are
useful in that they provide visualization of the relationship between two variables. An
equation is a more concise presentation of a relationship and is essential for the
forecasting of economic behavior
Important Terms
Ceteris paribus. A Latin phrase meaning "other things being equal." This assumption
is used in modeling to indicate that the value of other independent variables are held
constant.
Dependent variable. A variable whose value depends upon another economic event.
For example, spending by an individual is dependent upon the receipt of income.
Economics. A social science that studies how individuals and organizations in
society engage in the production, distribution, and consumption of goods and
services.
Economic theory or model. A generalization and abstraction of reality that seeks to
isolate a few of the most important determinants (causes) of an economic event in
order to provide a better understanding of that event. Such models are used to
develop policies that might prevent, correct, or alleviate economic problems.
Independent variable. A variable whose value determines the value of another
(dependent) variable. For example, an individual's income largely determines the
amount that an individual can spend.
Macroeconomics. The study of aggregate economic activity, such as the economy's
level of output, level of national income, level of employment, and general price
level.
Microeconomics. The study of economic behavior of individual decision-making
units, such as consumers, resource owners, and business firms in a free-enterprise
economy.
Outline of Chapter 1: Introduction to Economics
1.1 The Subject Matter of Economics
1.2 The Methodology of Economics
1.3 The Use of Tables, Graphs, and Equations
1.1 THE SUBJECT MATTER OF ECONOMICS
Economics is a social science which studies individuals and organizations engaged in
the production, distribution, and consumption of goods and services. The discipline
of economics has developed principles, theories, and models which isolate a few of
the most important determinants or causes of economic events. The goal is to predict
economic occurrences and to develop policies that might prevent or correct such
problems as unemployment, inflation and waste in the economy.
Economics
is
subdivided
into
macroeconomics
and
microeconomics.
Macroeconomics studies aggregate output and employment, the general price level,
and the balance of payments. Microeconomics studies the economic behavior of
individual decision-making units such as consumers, resource owners, and business
firms in a free-enterprise economy.
EXAMPLE 1.1. Economic conditions greatly affect all of us throughout our lives.
They determine where we live what we eat, what school we attend, whether we go to
work or to college, what job we get, and how much we earn. Economic conditions
affect the peace and stability in our cities and in the world. Problems of
unemployment and inflation fill the front pages of our newspapers and news
programs. It is practically impossible in today's complex world to be a responsible
citizen without having some grasp of economic issues and principles. Economics
seeks to give us a better understanding of how our economy operates and what can be
done to avoid, correct or alleviate unemployment, inflation, and waste.
1.2 THE METHODOLOGY OF ECONOMICS
Because economic phenomena are complex, economists have found it useful to
model economic behavior. In constructing a model, economists take assumptions
which cut away unnecessary detail and reduce the complexity of economic behavior.
Once modeled, economic behavior may be presented as a relationship between a
dependent variable and few independent variables. The behavior being explained is
the dependent variable; the variables explaining that economic behavior are the
independent variables. Frequently, the dependent variable is presented as depending
upon one independent variable, with the influence of the other independent variables
held constant. Thus, y depends upon ceteris paribus (ceteris paribus means that other
independent variables are held constant).
EXAMPLE 1.2. A manufacturer of compact discs must anticipate the quantity (of
compact discs that individuals will buy. Purchases, and therefore demand, are
probably influenced by a large number of variables: (I) the price of each compact
disc; (2) the price of compact disc players; (3) the price of' tapes; (4) the price of tape
decks; (5) people's income; (6) the desire to listen to music rather than watch videos;
(7) and other nonspecified variables. Forecasting the demand for compact discs
becomes a formidable task if we attempt to take into account all the variables that
could affect demand. If one variable is largely responsible for demand. a manageable
forecasting task exists. It is reasonable to assume that price is the most important
variable influencing the purchase of compact discs; the demand for compact discs is
therefore presented as Qd
compact discs=f
(P
compact discs),
ceteris paribus; the quantity of
compact discs demanded (Qd) depends upon the price (P) of a compact disc, with the
influence of other independent variables held constant. Qd compact discs is the dependent
variable which is determined by the price of compact discs, the independent variable.
An economic model will also specify whether the dependent and independent
variables are positively or negatively related. The relationship is positive when the
dependent variable moves in the same direction as the independent variable; the
relationship is negative when tie value of the dependent variable increases when the
value of the independent variable decreases. In the model of the demand for compact
discs, we expect a negative relationship the more compact discs are purchased. the
lower the price of each compact disc.
1.3 THE USE OF TABLES, GRAPHS, AND EQUATIONS
Models which simplify economic reality provide the framework for organizing data,
empirically testing economic hypotheses, and forecasting economic behavior In
Examples 3 through 6, we model consumer spending, present data on consumer
spending for a hypothetical economy. graph the data. establish an equation for
consumer spending, and then use the equation to forecast consumer spending.
EXAMPLE 1.3. we shall assume that the amount a consumer spends (C) is
positively related to the receipt of disposable income (Yd), i.e., C = f(Yd) table 1-1
presents data on consumer spending for live individuals with different levels of
disposable income. As we can see from the table, consumption and disposable
income display a positive relationship.
Table 1-1
Individual
A
B
C
D
E
(in $)
Disposable Income (Yd)
20,000
21,000
22,000
4,()QQ
27.000
Consumption (C)
20,000
20,750
21,500
23,000
25,250
EXAMPLE 1.4. The data from Table 1-1are plotted in Fig. 1-1 and labeled C1.
Consumer spending is plotted on the vertical axis and disposable income is plotted on
the horizontal axis. (The dependent variable normally appears on the vertical axis and
the independent variable on the horizontal axis.) Graphs visually present data and the
positive or negative relationship of the dependent and independent variable.
EXAMPLE 1.5. Although Fig. 1-1 is visually informative, it does not provide us
with sufficient information to predict the amount an individual with a $30,000
income will spend. Since the relation between consumption and disposable income is
linear in Fig. 1-1, consumer spending behavior can be presented by the linear
equation C=$5000 + 0.751Yd, Substituting Yd = $20,000 into the equation, we find
that C = $20.000 when Yd is $20,000, which is consistent with the consumption and
disposable income individual A in Table 1-1, C = $5000 + 0.75($20,000);
C = $5000 + $15,000; C= $20,000.) We use the consumer spending equation to
forecast that a consumer with a $30,000 income will spend $27,500.
Solved Problems
THE SUBJECT MATTER OF ECONOMICS
1.1. (a) Explain the statement "Economics is a social science."
(b) Why is the study of economics important?
(a) The social sciences study how society is organized and functions.
Economics, sociology, anthropology, psychology, and political science are
all social sciences. Each studies the organization and functioning of society
from a particular point of view. Economics studies how individuals and
organizations in society engage in the production, distribution, and
consumption of goods and services.
(b) An understanding of basic economic issues and principles is essential for a
well-informed and responsible citizen. Our newspapers and news programs
are filled with information about unemployment, inflation, price controls,
taxes, energy, imports, monopoly power of large corporations, and other
problems. Without some knowledge of economics, it is practically
impossible to understand the issues involved and form sensible opinions on
these important matters. Economics can also help individuals to operate their
businesses and control their personal finances by providing a basis for
understanding how to protect or reduce the impact of inflation, how tax
reforms and energy conservation programs affect them, and so on.
1.2. Distinguish between macroeconomics and microeconomics.
Macroeconomics studies the economy as a whole or its major components
such as households, business, and government. It deals with the price level
and with the level of total output, employment, and national income. It also
analyzes total private expenditures, total investments, total government
expenditures, and total imports and exports of goods and services. It seeks
to explain the causes of unemployment, inflation, and balance-of-payments
deficits in order to formulate and implement economic policy.
Microeconomics, on the other hand. studies the economic behavior of
individual decision-making units such as consumers, resource owners, and
business firms in a free-enterprise system (an economic system in which
the government does not directly control economic activity). It deals with
how an individual consumer spends income to maximize satisfaction, how
a business firm combines resources or factors of production to maximize
profits, and how the price of each commodity and each type of resource is
determined by supply and demand. It studies how these individual
decisions are affected by different forms of market organization.
THE METHODOLOGY OF ECONOMICS
1.3. (a) How are economic models and theories developed? What is their
function?
(b) What are some of the difficulties associated with the study of economics?
(a) Economic models and theories are abstractions and generalizations of
reality. They seek to cut through the many details surrounding an economic
event to arrive at and isolate a few of its most important causes or
determinants. For example, there are many causes of inflation, but if we
can identify a few of the most important ones we may be able to reduce or
largely eliminate inflation. Thus, economic models help us understand
economic phenomena so that we can explain and possibly predict a
recession, a period of inflation, and other important economic events.
(b) There are a number of difficulties associated with the study of economics.
(1) We may have preconceived notions about the cause and cure of an
economic problem which are not supported by actual economic behavior
(2) Generalizing from individual experiences often leads to wrong
conclusions (this is called the fallacy of composition). For example, when
an individual increases his or her savings, that individual becomes richer,
but when society as a whole saves more by demanding fewer goods and
services it may become poorer by putting people out of work. (3) The fact
that one economic event precedes an-other does not necessarily imply
cause and effect. For example, the collapse of the U.S. stock market in
1929 did not cause the worldwide Great Depression of the 1930s. (4) Since
economics is a social science and laboratory experiments cannot be
conducted, economic theories can only describe expected behavior Thus,
economic theories are not as precise or reliable as the natural laws
established in the pure sciences.
1.4. (a) Why are models used in economics?
(b) Suppose we are analyzing an individual's demand for videos. Identify
whether the following variables are dependent or independent variables:
quantity of videos demanded (Qd videos), the individual's disposable income
(Y), the price of each video (P videos), the cost of renting a video (P rental).
(c) Use part (b) to present the dependent variable as a function of the
independent variables.
(d) Would you expect the dependent variable to have a negative or positive
relation to the independent variables?
(a) A model simplifies reality. In abstracting from reality, a dependent variable
is explained by a limited number of independent variables.
(b) Quantity of videos demanded is the dependent variable since this is what we
are trying to explain. The other variables are independent variables which
help explain how many videos an individual wants to buy. For example,
disposable income is one of the variables that influences the number of
videos a person can afford. The price of a video is important, as is the cost of
renting a video rather than purchasing one.
(c) The quantity of videos demanded is dependent upon (is a function of) an
individual's disposable income, the price of each video, and the cost of
renting videos. Using notation, the relationship between the dependent and
independent variables can be presented as Qd videos = f(Y, P videos, P rental),
where Y represents an individual's disposable income.
(d) We would expect the quantity of videos demanded to be positively related to
disposable income, i.e., the more spendable income a person has, the more
videos this person can afford. The quantity of videos demanded would be
negatively related to price since an individual is more likely to purchase a
video when each video is priced at, say, $15 rather than $30. The quantity of
videos demanded is positively related to the cost of renting a video since
more videos would be purchased the higher the cost of renting a video.
1.5. (a) The demand for videos might be presented as a function of the video's
purchase price. Does this mean that income and the cost of renting a video
are unimportant?
(b) What is the meaning of and the economist's use of the term ceteris paribus?
(a) To further simplify the demand-for-videos function–Qd videos = f(Y, P videos, P
rental)–we could assume that the individual's disposable income and cost of
renting videos are unchanged. Thus, while income and rental cost influence
the demand for videos, more videos are purchased only because of a lower
price for videos since the individual's disposable income and the cost of
renting a video are unchanged.
(b) The term ceteris paribus means that other independent variables affecting
the dependent variable are held constant, or are unchanged. When other
independent variables that influence the quantity of videos purchased are
held constant, the demand for videos can be presented as Qd videos = f(P videos),
ceteris paribus.
THE USE OF TABLES, GRAPHS, AND EQUATIONS
1.6. What is a graph?
A graph is a visual presentation of the behavior of a variable over time
(a time series graph) or of the relationship between two variables. A time
series graph shows, for example, the level of interest rates over successive
months or years. In the graphic presentation of the relationship between
two variables, one variable is plotted on the horizontal axis and the other
on the vertical axis. Graphs are useful in that they help establish
relationships. Whereas a verbal explanation may be misinterpreted, a graph
provides a visual presentation which is easily recalled.
1.7. Why is there extensive use of graphs in economics?
Economic relationships can be enhanced by a graph. For example,
suppose a market researcher polls college-age students in metropolitan
Boston to find the number of them that are interested in purchasing a travel
package to Florida. Suppose the polltakers find that 100 would purchase a
six-day package at $900, 200 at $800, 400 at $700, and 800 at $600.
Obviously, more students are interested in purchasing the travel package at
a lower price. The relationship between package price and positive
responses is illustrated in Fig. 1-2 by demand curve D where the price (P)
of the travel package is plotted on the vertical axis and the number of
positive responses (quantity, Q) is plotted on the horizontal axis. In
studying these responses, we find that the number of positive responses
doubles for each $100 decrease in the price of the travel package.
1.8. Table 1-2 presents the number of 19-inch color TVs individuals are willing to
purchase at various prices in City A and in City B.
(a) Plot these data, with price (P) on the vertical axis and quantity (Q) on the
horizontal axis; set price increments at $25 and quantity increments at 25
units. For City A, connect the points which represent the price and quantity
demanded and label the line D1. Do the same thing for the points for City B
and label the line D2.
(b) Find the increase in the quantity of TV units purchased in City A and City B
when the price of TVs is lowered from $300 to $275.
(c) The slope of a straight line is the change in the vertical axis (in this example
AP) divided by a change in the horizontal axis (here Q). Find the slope of
demand lines D1 and D2 in Fig. 1-3 when the price is lowered from $300 to
$275. Which demand line is more steeply sloped?
(d) What does the difference in the slope of demand lines D1 and D2 indicate?
Table 1-2
Price
$350
$325
$300
$275
$250
Quantity Demanded in
City A
City B
100
75
150
100
200
125
250
150
300
175
(a) See Fig. 1-3.
(b) The quantity of TVs purchased in City A increases 50 units when the price
of TVs is lowered $25; the quantity of TVs purchased in City B increases 25
units when the price is lowered $25.
(c) The slope of demand line D1 is 0.50 (P/Q = $25/SO = 0.50), while the
slope of D2 is 1.00. The slope of demand line D2 is greater, indicating that it
is more steeply sloped.
(d) A more steeply sloped demand line indicates that a change in price is
associated with a smaller change in quantity demanded.
1.9. Replot the data from Table 1-2. Again plot price on the vertical axis in
increments of $25, but this time plot quantity demanded on the horizontal axis in
increments of 50 rather than 25.
(a) Visually compare the demand lines in Figs. 1-3 and 1-4. Does it appear that
the steepness of the demand lines has changed? Has the slope of either
demand line changed?
(b) Can one misinterpret the strength of the relationship of two variables by
visual inspection of the data?
(a) It appears that demand lines D1 and D2 are more steeply sloped in Fig. 1-4
than in Fig. 1-3. However, the slope of the demand lines has not changed
since P/Q is unchanged.
(b) One cannot reach conclusions about the sensitivity of one variable to another
from visual inspection of a graph since the choice of scale affects the
steepness of the relationship. For example, the demand lines in Fig. 1-4
appear steeper because the unit interval along the quantity axis is 50 while
the unit interval is
25 in Fig. 1-3.
1.10. Figure 1-5 plots the average yield on 3-month Treasury bills from 1980
through 1993. In what way does this graph differ from the graph in Fig. 1-4?
Figure 1-5 is a time series graph in which the behavior of a single variable
has been presented at various time intervals. Fig. 1-4 presents the relationship
of two variables, price and quantity. The relationship between two variables
can be presented over periods of time (in a time series graph) or at a point in
time. Most of the two-variable graphs presented in this book will depict the
relationship of two variables at a point in time.
1.11.Suppose consumption spending is presented as C = $50 + 0.50Yd, where C
represents the amount consumed and Yd represents disposable income.
(a) Create a table that shows the amount consumed when disposable income is
$150, $200, $250, $300, and $350.
(b) Graph the data from the table and label the line C1.
(c) Suppose the consumption spending equation changes from C = $50 +
0.50Yd to C = $75 + 0.50Yd. Plot the new consumption equation on the
same graph and label it C2. What happens to the consumption line when the
constant of the consumption equation increases from $50 to $75?
(a)
Table 1-3
Disposable Income
Consumption
$150
$125
$200
$150
$250
$175
$300
$200
$350
$225
(b) See Fig. 1-6.
(c) See Fig. 1-6. The consumption line shifts upward by $25 when the
constant of the consumption equation increases $25.
Multiple Choice Questions
1. Economics studies individuals and organizations in society engaged in the
(a) production of goods and services,
(b) distribution of goods and services,
(c) consumption of goods and services,
(d) all of the above,
(e) none of the above.
2. Economic principles, theories or models
(a) seek to explain and predict economic events in the hope of developing
policies to correct economic problems,
(b) identify all of the numerous detailed causes of an economic event,
(c) develop rules of individual behavior in order to generalize and predict
society's economic behavior,
(d) all of the above.
3. Which of the following does not refer to macroeconomics?
(a) The study of aggregate economic activity,
(b) The study of the economic behavior of individual decision-making
units such as consumers, resource owners, and business firms,
(c) The study of the causes of and policies to remedy unemployment,
(d) The study of the causes of inflation.
4. Which of the following is a correct statement?
(a) The value of an independent variable depends upon the value of a
dependent variable.
(b) The term ceteris paribus is used when the value of a dependent variable
is held constant.
(c) The term ceteris paribus is used when the value of a dependent variable
is changing.
(d) The term ceteris paribus is used when the value of an independent
variable is held constant.
5. When the value of an independent variable increases, the value of the
dependent variable
(a) also increases when there is a positive relationship,
(b) also increases when there is a negative relationship,
(c) decreases when there is a positive relationship,
(d) decreases when there is no relationship between the two variables.
6. In the statement "Quantity demanded is a function of price,"
(a) quantity demanded is the dependent variable and price is the
independent variable,
(b) price is the dependent variable and quantity is the independent variable,
(c) quantity demanded and price have no relationship.
7. Ceteris paribus is used in economics when
(a) two variables are positively related,
(b) two variables are negatively related,
(c) the value of an independent variable affecting the dependent variable is
held constant,
(d) the value of a dependent variable affecting the independent variable is
held constant.
8. In the equation C = $10 + 0.90}'d,
(a) C (consumption) is $90 when Yd (disposable income) is $100,
(b) C (consumption) is $190 when Yd (disposable income) is $200,
(c) C (consumption) is $270 when Yd (disposable income) is $300,
(d) C (consumption) is $390 when Yd (disposable income) is $400.
True or False Questions
9.
Economic models and theories are accurate statements of reality.
10. Microeconomics deals with concerns such as the price level and the level of
employment.
11. In the statement "Consumption is a function of disposable income,"
consumption is the dependent variable.
12. Two variables are positively related when their values move in the same
direction.
13. The value of the independent variable is determined by the value of the
dependent variable.
14. Graphs provide a visual representation of the relationship between two variables.
15. In the equation Qd = 100 - 5P, Qd is 50 when P is 10.
1. (d)
2. (a)
3. (b)
4. (a)
Answers to Multiple Choice and True or False Questions
5. (a)
9. (F)
13. (F)
6. (a)
10. (F)
14. (T)
7. (c)
11. (T)
15. (T)
8. (b)
12. (T)