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Economics: A Contemporary Introduction

7th Editionby

William A. McEachern

PowerPoint Slides

prepared by

Dale BailsChristian Brothers University

© 2006 Thomson/South-Western

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The Art and Science of Economics

Chapter 1

© 2006 Thomson/South-Western

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The Economic Problem

Economics examines how people use their scarce resources to satisfy their unlimited wants

Scarce resource Not freely available when its price exceeds zero

Resources Inputs Factors of production Used to produce goods and services

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Resources

Goods and services are scarce because resources are scarce

Four general categoriesLaborCapitalLandEntrepreneurial Ability

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Labor and Capital

Labor: broad category of human effort Physical and mental Time Scarcity of time scarcity of labor

Capital: Human creations used to produce goods and services Physical capital: factories, machines, tools,

buildings, airports, highways and other manufactured items employed to produce goods and services

Human capital: consists of the knowledge and skill people acquire to enhance their labor productivity

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Land &Entrepreneurial Ability

LandLand and other natural resourcesGifts of nature including bodies of water,

trees, oil reserves, etc.

Entrepreneurial AbilitySpecial kind of human skillTalent required to dream up a new product

or find a better way to produce an existing one

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Payments for Resources

Wages payment for use of labor

Interest payment for the use of capital

Rent payment for use of land

Profit reward for entrepreneur’s reward

Revenue from sales minus cost of resources employed Claims what is left over after paying for other resources

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Goods and Services

Goods Tangible items

Services Intangible items

Good or service is scarce if the amount people desire exceeds the amount that is available at a zero price we must continually choose among them Choices in a world of scarcity implies we must pass up some

goods and services

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Free Goods

Goods that are available at a zero price

Even these goods may come with strings attached

For example, while air and seawater may appear to be free, clean air and seawater have become scarce

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Economic Decision Makers

Four types of decision-makers in the economy Households

Demand the goods and services produced Supply labor, capital, labor, and entrepreneurial ability

Firms, governments, and the rest of the world Demand the resources Supply the goods and services Rest of the world foreign households, firms and

governments

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Markets

Means by which buyers and sellers carry out exchanges

Product markets Markets in which goods and services are bought and

sold

Resource Markets Markets in which the resources are exchanged Labor, or job, market is the most important of the

resource markets

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Exhibit 1: Circular-Flow Model

Households supply resources in the resource market and demand goods and services in the product marketFirms supply goods and services in the product market and demand resources in the resource marketMoney flows in resource markets determine wages, interest, rents and profits which flow as income to householdsProduct markets determine the prices for goods and services which flow as revenue to firms

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Rational Self Interest

Maximizing the expected benefit achieved with a given cost or minimizing the expected cost of achieving a given benefit

Self Interest

Rational – people try to make the best choices they can, given the available information

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Time and Information

Time and information are both scarce and valuable

Often willing to pay others to gather and digest it for us

Decision-makers will continue to acquire information as long as the additional benefit expected from that information exceeds the additional cost of gathering information

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Marginal Analysis

Comparison of expected marginal cost and the expected marginal benefit of the action under consideration

MarginalIncrementalAdditionalExtra

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Micro and Macro “economics”

MicroeconomicsExamines the factors that influence individual

economic choices Studies the individual pieces of the economic

puzzle

MacroeconomicsStudies the performance of the economy as a

wholeFocuses on the big picture

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Science of Economic Analysis

Economic theory or model

Simplification of economic reality

Used to make predictions about the real world

Focuses on the important elements of the problem under study

More details more unwieldy

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Exhibit 2 The Scientific Method1. Identify the Question and Define Relevant Variables

2. Specify Assumptions

or

3. Formulate a hypothesis

4. Test the hypothesis

Reject the hypothesis

Use the hypothesis until a better one shows up

Modify Approach

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Scientific Method

Identify the Question and Define the relevant variables Variable is a measure that can take on different

values

Specify Assumptions Other-things-constant assumption: ceteris paribus Behavioral Assumption refer to how people behave

rational self-interest consumers maximize satisfaction and firm maximizes profits

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Formulate and Test Hypothesis

Statement about how the key variables relate to each other

Provides the predictions of interest based on cause and effect relationships

Test involves comparing these predictions with real world

This is where the validity of theory is tested

We reject the theory if it predicts worse than the best alternative

We accept the theory until a better one comes along

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Normative versus Positive

Positive economic statementAssertion about economic realitySupported or rejected by reference to the

facts

Normative economic statementOpinionsCannot be shown to be true or false by

reference to the facts

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Predicting Average Behavior

Because the unpredictable actions of numerous individuals tend to cancel one another out, the average behavior of a group of individuals can be predicted more accurately than the actions of any one individual

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Pitfalls of Economic Analysis

Three possible sources of mistakes in reasoning leading to faulty conclusions

Fallacy that Association is Causation

Fallacy of Composition

Mistake of Ignoring Secondary Effects

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Pitfalls of Economic Analysis

Fallacy that Association is Causation Event A caused event B simply because the two are

associated in time The fact that one event precedes another or that the

two events occur simultaneously does not necessarily mean that one event caused the other

Fallacy of Composition Erroneous belief that what is true for the individual

or the part, is also true for the group, or the whole

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Ignoring Secondary Effects

Unintended consequences of policies or choices

Primary Effects Effects that are felt relatively quickly Easily observed

Secondary Effects Tend to develop more slowly Frequently not obvious