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Economic Thinking and
Economic Tools
Chapter 2
Economic Thinking
Normative vs. Positive Statements
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Normative: What Should be
Positive: What is
In Principles of Economics we stated:

Economics uses positive statements
In this Course we state:

Economics attempts to be about Positive
Statements
Economic Thinking
Problem In Analyzing Economic
Problems is that
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Perceptions may confuse issues
Personal Bias
Cultural Bias
Other Issues
Conventional Wisdom
Economic Thinking
Example:
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In May of 2003, Jayson Blair a reported for
the New York Times is fired because of
numerous false information in his articles.
He was discovered because he plagiarized
an article from the San Antonio Express
Mr. Blair is an African American
Economic Thinking
Example (cont):

The fact that Mr. Blair is an African
American is to some proof that affirmative
action leads firms to promote based on
race or ethnicity and not on merit
Economic Thinking
Example (cont):

Columnists Howard Kurtz (CNN), William
Safire (New York Times), and Tim Rutten
(Los Angeles Times), among others
conclude that race was a factor in the
continuation of Mr. Blair as a reporter even
after internal memos indicated there was
grave problems with his reporting
Economic Thinking
Example (cont):
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To those opposing affirmative action this is
clear evidence of the problem it creates
The evidence is clear, he was only
promoted because of the “race thing”
Economic Thinking
Example (cont):

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Those who support affirmative action, on
the other hand, indicate this is an example
of how only when minorities are involved in
the same mistakes committed by nonminorities is race become an issue.
For instance, Terry Neal (Washington Post)
and Seth Mnookin (Newsweek) argue that
race was not an issue
Economic Thinking
Example (cont):

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Terry Neal relates the example of Stephen Glass
(New Republic) who not only fabricated stories as
Mr. Blair has done but went as far as creating Web
sites and voice mails to support his fabrications
Also, R. Foster Winans (Wall Street Journal) who
in 1985 was convicted for writing false articles for
the purpose of making money in the stock market
Economic Thinking
Example (cont):

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In none of these cases was there a
condemnation that a system that is not
minority friendly results in lower quality
white reporters not being fired earlier
Who is right?
Both arguments are probably right
and wrong at the same time
Economic Thinking
In the Summer of 2003 the Supreme
Court upheld the University of
Michigan’s Law school admission policy
but not that of its undergraduate
program
Difference in the policies
Economic Thinking
In writing for the majority, Justice O’Connor
indicate that “American businesses have
made clear that the skills needed in today’s
increasingly global marketplace can only be
developed through exposure to widely
diverse people, cultures, ideas, and
viewpoints.” She went on to say that she
expected that in 25 years these type of
procedures would not be needed
Economic Thinking
On the other hand, writing a dissenting
opinion Justice Thomas states: “these
programs [affirmative action] stamp minorities
with a badge of inferiority and may cause
them to develop dependencies or to adopt an
attitude that they are ‘entitled’ to preferences.”
Economic Thinking
Economics of the science of how
individuals go about the business of
satisfying their wants given scarce
resources
The word Scarcity is crucial
Scarcity leads to Opportunity Cost
Microeconomics
The Basic Approach
Choices

Opportunity Cost
Maximization
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Constraint Maximization
Example
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Choose X to maximize V(X) subject to the constraint
involving X and Z
Max U(X1,X2) s.t. I = P1* X1 + P2* X2
Microeconomics
The Basic Approach (Cont)
We have two sets of variables:
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Endogenous (solved by the system)
In this case X1 and X2
Exogenous (values given outside the
system)
In this case I, P1, and P2
Microeconomics
The Basic Approach (Cont)
From the utility maximization we derive
the demand curve.
In this case,

D1 =F(P1, P2, M)
Next, we are interested on how the the
solutions change when an exogenous
variable changes
Microeconomics
The Basic Approach (Cont)
The Law of Demand
ΔD1/ΔP1 <0
Substitutes vs. Compliments
ΔD1/ΔP2 < or > 0?
Normal vs. Inferior Goods
ΔD1/ΔI < or > 0?
Demand and Supply
Law of Demand
Relative Price
Income and Substitution Effect
Things that may impact demand
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Price of own good,
Price of substitute and compliment goods
Income
Demand and Supply
Things that may impact demand (Cont.)
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Preferences
Number of buyers
Etc.
Demand
P
Increase in quantity
demanded
Decrease in
quantity demanded
D
Q
Demand
P
Exogenous variable
increases demand
D
Q
Demand
P
Exogenous variable
decreases demand
D
Q
Demand and Supply
Law of Supply
Relative Price
Income and Substitution Effect for
Labor
Things that may impact supply
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Price of own good,
Price of substitute and compliment goods
Cost of Inputs
Demand and Supply
Things that may impact supply (Cont.)
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technology
Number of sellers
Etc.
Supply
P
S
Q
Supply
P
S
Increase in supply
Q
Supply
P
S
Decrease in supply
Q
Demand and Supply
P
S
P*
D
Q*
Q
Demand and Supply
(Increase in Demand)
P
S
Equilibrium Price
increases and equilibrium
quantity also increases
P*
P
D
Q Q*
Q
Demand and Supply
(Increase in Supply)
P
S
Equilibrium Price
decreases and equilibrium
quantity increases
P*
P
D
Q* Q
Q
Demand and Supply
(Decrease in Demand)
P
S
Equilibrium Price
decreases and equilibrium
quantity also decreases
P*
P
D
Q
Q*
Q
Demand and Supply
(Decrease in Supply)
P
S
Equilibrium Price increases and
equilibrium quantity decreases
P
P*
D
QQ*
Q
Demand and Supply
P
S
Excess Demand
D
Q
Demand and Supply
P
Excess Supply
S
D
Q
Demand and Supply of Labor
w
S
D
L
Demand for Labor
Reasons why it slopes downward:
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Law of Diminishing Marginal Returns
Substitution Effect
Scale Effects
Supply of Labor and
Equilibrium
Why Supply Slopes Upwards then
downwards
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Income and Substitution Effect
Stable Equilibrium
Equilibrium
If w > we then there is an Excess
Supply which implies there is
unemployment
If w < we then there is an Excess
Demand which implies there is an tight
labor market
Shocks to Equilibrium:
Demand
DEMAND
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Output becomes more or less “popular”
Shift to more efficient capital
Competitiveness in output market changes
Technology
Shocks to Equilibrium:
Supply
Supply
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Change in Labor size
 Women enter the market place
 Immigration
 Taxes
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Change in Quality of Labor
 Education
 Cultural Change
Draft vs. No Draft
Assume that the military in this
economy is deciding whether to ask
civilian government whether to institute
a draft or not.
Clearly wages will be lower with the
draft and will not cause an excess
demand (since there is a draft)
Draft vs. No Draft
S
w
wND
wD
D
LND
LD
L
Draft vs. No Draft
Is Draft Cheaper?
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Government:
 Yes if Yellow box is larger than brown box
 No if the opposite is true
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Society
 No, since the opportunity cost of some of those
drafted are likely to have higher
How Would Arm Forces Differ
Under the Draft
Draft:
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Larger, could have soldiers with higher
opportunity cost.
May not be better due to the possibility of
low moral.
How Would Arm Forces Differ
Under No Draft
No Draft:
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Smaller
Maybe Lower Opportunity Cost
 Low Education
 “taste” for soldiering
 Perhaps Racial Component
Equity vs. Efficiency
No Draft:
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Efficient
In other words Draft is inefficient
Draft:
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Could be more equitable
Economic Thinking and
Economic Tools
More about regression analysis later
More about experimental economics
later